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Derivatives Markets in India

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A Study on Derivatives Market in India: Current Scenario and Future Trends.

By

Riddhi Kapadia

2006

A Dissertation in part consideration for the degree of MA Finance and Investment

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Derivatives Markets in India

"Dedicated to my family for all the sacrifices they have done For making me who I am."

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Derivatives Markets in India

Abstract

The derivative market has become multi-trillion dollar markets over the years. Derivatives are financial commitments indexed or linked in some capacity to changes in the value of underlying assets. The bulk of the derivatives trading internationally are linked to currencies and interest rates, other derivatives are linked to equity or equity indices. A very small volume of derivatives, compared to the total, is indexed to traditional commodities. Small by comparison to other derivatives markets, these commodities-indexed derivatives markets are large compared to the underlying physical commodity markets.

The Aims and Objectives of this research are to have an in-depth knowledge of the derivative markets in India and in this report entitled `A Study on Derivatives Market in India ­ Current Scenario and Future Trends', I have tried my level best to make it simple and understandable.

Questionnaires, sampling and personal interviews were conducted for answering the research questions and achieving aims and objectives of research. The findings were in favour of derivatives being vital for the stock market and they are not diminishing in today's world, but they are at the booming stage; and every institutional investor would want to use derivative as a tool to maximise its profits.

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Derivatives Markets in India

The research deals with basics of derivatives and its evolution in India. Also statistics about the global derivatives market is given and it is heartening to know that India's NSE ranked 20th during 2006 in the global derivative market. In the later part of the research evolution, current scenario and prospects of equity derivatives are discussed. In the concluding section, the use of derivatives by various financial institutions and obstacles to derivative market development is debated. In the report it is concluded that the derivatives market will continue to grow, and there is a need to remove the obstacles in its way. Also, more products should be introduced in the derivatives market.

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Acknowledgements

I am indebted to my family and friends for the understanding and support they have given me during the writing of this dissertation.

In particular, I thank my parents, Mr. Nishith and Mrs Ashita Kapadia and my friends for their inspiration and encouragement to complete my tasks.

I also thank Mr. Vijay Kanchan for remembering who I was , and never let me lose hope when I was lost , for having faith in me all such times, and encouraging me to prove my worth.

Finally, I give a million thanks and regards to Dr. Peter Oliver for his constant support and supervision through out this research. He never let me go out of the office without a smile and believed that I can do it.

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Table of Contents: Abstract...............................................................................................3 Acknowledgements.................................................................................5 Chapter 1 Introduction............................................................................7 1.0 Context...........................................................................................7 1.1 Aims and Objectives..........................................................................7 1.2 Background.....................................................................................8 1.2(a) Evolution of Derivatives Trading in India.........................................11 1.2(b) A Brief History of Forward Trading................................................15 1.3 Structure of Dissertation.....................................................................20 Chapter 2 Literature Review....................................................................22 2.0 Forwards.......................................................................................23 2.1 Functions of Derivative Market............................................................31 2.2 Evolution of Equity Derivatives and its Present Status...............................41 Chapter 3 Research and Methodology.........................................................63 3.0 Introduction....................................................................................63 3.1 Methods of Collection of Data.............................................................64 3.2 Research Process.............................................................................72 3.3 Research Design..............................................................................74 3.4 Sampling.......................................................................................74 3.5 Questionnaire Design........................................................................75 3.6 The Interviews.................................................................................77 Chapter 4 Data Analysis and Findings........................................................79 4.0 Introduction....................................................................................79 4.1 STEEPLE Analysis...........................................................................97 4.2 Summary of Conclusions..................................................................118 4.3 Recommendations...........................................................................122 References.........................................................................................125 Appendix...........................................................................................135

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Chapter 1 Introduction

1.0 Context After studying the general financial tools, practices and mutual funds and industry trends this decision was taken to choose the area of research where the author was employed in the stock market i.e. equity market in India (Mumbai) known as the leader in the `Stock Market in India'. Through preliminary research and examining their methodologies and tools, worked with company's management and the stock market was found that India's stock exchange i.e. NSE and BSE were one of the earlier markets, which invited derivatives to enhance their effectiveness in business. The fact that derivatives in any industry plays a vital role for making profits for the company. It is also one of the untouched areas in the Nottingham Business School, and so it was decided to do dissertation on this topic and a written approval from the Management of Mutual Fund Company i.e. Kabra Mutual Fund Ltd for this project was taken.

1.1 Aims and Objectives

The aim of this research is to study the derivative market in India and its current and future trends ,which are carried out on the stock (equity) market.

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The objectives of the study are as follows:

· · · · · · ·

To have an overview of the Indian Derivative Market. To assess risk management tools and its strategies. To evaluate products of derivatives i.e. Forwards, Futures, Swaps and Options. To critically analyse its participants i.e. Hedgers, Speculators and Arbitrageurs. To evaluate the functions of derivatives. To analyse the trends of working and the future trends of Equity Derivatives. To propose conclusion and recommendation based upon the findings.

1.2 Background

Avadhani (2000) opines that the "History of financial markets is replete with crises, such as the collapse of the fixed exchange rate system in 1971, the Black Monday of October 1987, the steep fall in the Nikkei in 1989, the US bond debacle of 1994, all these events occur because of very high degree of volatility of financial markets and their unpredictability. Such disasters have become more frequent with increased global integration of markets. Innovative financial instruments have emerged to protect against hazards, these include Future and Options, which are the most dominant forms of financial derivatives, since such volatility and associated disasters cannot be washed away. They are called derivatives because their values are derived from an underlying primary financial instrument, commodity or index, such as interest rates, exchange rates, commodities and equities. For examples, a commodity future price depends on the value

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of the underlying commodity; the price of a stock option depends on the value of the underlying stock and so on. A derivative provides a mechanism, which market participants use to hedge their position against the adverse movement of variables over which they have no control. Avadhani (2000) continues Financial derivatives came into the spotlight along with the growing instability in current markets during the post- 1970 period, when the US announced its decision to give up gold- dollar parity, the basic king pin of the Bretton Wood System of fixed exchange rates. The derivative markets became an integral part of modern financial system in less than three decades of their emergence. According to Greenspan (1997) "By far the most significant event in finance during the past decades has been the extraordinary development and expansion of financial derivatives..."

Derivatives include a wide range of financial contracts, including forwards, futures, swaps and options. The International Monetary Fund (2001) defines derivatives as "financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues." While some derivatives may have complex structures, all of them can be divided into basic building blocks of forward and option contracts or some combination thereof. For the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio risks, derivatives allow financial institution and other participants to identify, isolate and manage separately the market

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risks in financial instruments and commodities. The risks that are associated with derivatives include credit risk, liquidity risk and market risk (comprising commodity price risk, currency, interest-rate risk and equity price risk.). The risks of derivatives are more directly related to size and price volatility of the cash flows they represent than they are to the size of the notional amounts on which the cash flows are based. In fact the risk of derivatives and cash flows, which are derived from them are usually only a small portion of notional amounts. Financial institutions may use derivatives as dealers and end-users. For example, an institution acts as a end-user when it uses derivatives to take positions as part of its proprietary trading or for hedging as a part of its asset and liability management; it acts as a dealer when it quotes bids and offers and commits capital to satisfying customers' demand for derivatives. The emergence of the market for derivative products most notably forwards, futures and options can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuation in asset prices. The financial markets can be subject to a very high degree of volatility by their very nature. It is possible to partially or fully transfer the price risks by locking-in assets prices, through the use of derivative products. As instruments of risk management, derivative products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investor.

Sahoo (1997) opines "Derivatives produce initially emerged, as hedging devices against fluctuation in commodity prices and commodity-linked derivatives remained the sole

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form of such products for many years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. In recent years, the market for financial derivatives both OTC (CF ­ Glossary of Terms) as well as exchange traded has grown both in terms of variety of instruments available, their complexity and also turnover." The factors generally attributed as the major driving force behind growth of financial derivatives are:

· · · ·

Increased volatility in asset prices in financial markets. Increased integration of financial markets with the international markets. Market improvement in facilities of communication and a sharp decline in costs. Providing economic agents a wider choice of risk management strategies through development of more sophisticated risk management tools.

·

Optimally combining the risks and returns over a large number of financial assets, leading to higher returns, reduces risk as well as transaction cost as compared to individual financial assets by innovations in the derivative markets.

1.2 (a) Evolution of Derivatives Trading in India

Shapiro (2000) opines all markets face different kind of risks. The derivative is one of the categories of risk management tools. As this consciousness about risk management capacity for derivative grew, the market for derivatives developed. Derivatives markets are generally an integral part of capital markets in developed as well as in emerging market economies. These instruments support business growth by disseminating effective

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price signals concerning indices, reference rates or other assets, exchange rates and thereby render both derivatives and cash markets more efficient. Possible adverse market movements offer protection through these instruments and can be used to offset or manage exposure by hedging or shifting risks particularly during the periods of volatility thereby reducing costs. By allowing the transfer of unwanted risk, derivatives can promote more efficient allocation of capital across the economy, increasing productivity in the economy. Though the commodity features trading has been in existence since 1953 and certain OTC derivatives such as Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRSs) were allowed by RBI through its guidelines in 1999, the trading in "securities" based derivatives on stock exchange was permitted only in June 2000. The discussion that follows is mainly focussed on "securities" based derivatives on stock exchanges.

According to Sahoo (1997) the legal framework for derivatives trading is a critical part of overall regulatory framework of derivative markets. This will be clear when discussed later on how the regulation and control of derivatives trading and settlement have been prescribed through suitable amendment to the bye-laws of the stock exchanges where derivatives trading were permitted. With the role of state intervention in the functioning of markets is a matter of considerable debate, it is generally agreed that regulation has a very important and critical role to ensure the efficient functioning if markets and avoidance of systemic failures. The purpose of regulation is to promote the efficiency and competition rather than impeding it.

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According to Hathaway (1998), while there is a perceived similarity of regulatory objective, there is no single preferred model for regulation of derivative markets. The major contributory factors for success or failure of derivatives market are market culture, the underlying market including its depth and liquidity and financial infrastructure including the regulatory framework. The efficiency of derivatives market can be impaired through government interventions. For example, governmental trade agreements or price controls aimed at stabilizing prices, which do not allow derivative market to flourish are such examples of government intervention. Further, since the financial integrity, efficiency, market integrity, integrity and customer protection which are the common regulatory objectives in all jurisdictions, are critical to the success of any financial market. Anyone responsible for operating such a market would have strong incentives independent of external regulation to ensure that these conditions are present in the market place. The incentives for self-regulation can be complemented through the observation of a successful regulatory system while reducing the incentives and opportunity for behaviour, which threatens the success and integrity of market (International Organization of Securities Commission 1996a). The derivatives market that have emerged will require legislation normally, which addresses issues regarding legality of derivatives instruments, specially protecting such contracts from anti-gambling laws, because these involve contracts for differences to be settled by exchange of cash, prescription of appropriate regulations and power to monitor compliance with regulation and power to enforce regulations. The type and scope of regulation also change, as the industry grows. Therefore, regulatory flexibility is critical to the long run success of both regulation and industry it regulates. It would be interesting to observe the historical

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evolution of development of derivatives market and then examine what needs to be done to build up these markets.

History of Derivatives: A Time Line

The Ancient: Derivatives

1400s -Japanese rice futures 1500s- Dutch tulip bulb options 1800s- Puts and options

The Recent: Financial Derivatives Listed Markets

1972- Financial currency futures 1973 - Stock options 1977 - Treasury bond futures 1981- Eurodollar futures 1982- Index futures 1983- Stock index options 1990- Foreign index warrants and leaps 1991- Swap futures 1992-Insurance futures 1993- Flex options

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OTC Markets

1981- Currency Swaps 1982 - Interest rate swaps 1983- Currency and bond options 1987- Equity derivatives markets 1988 ­ Hybrid derivatives Source: Fortune India, September 16-30, 1993

1.2(b) A Brief History of Forward Trading

Sahoo (1997) opines the precursor to exchange based derivatives in India was kind of "forward trading" in securities in the form of put option (mandi), call options (teji), and straddle (fatak) etc. The Securities Contract Regulation Act, 1956(SCRA) was enacted, inter-alia, to prevent undesirable speculation in securities. The contracts for "clearing commonly known as "forward trading" were banned by the Central Government through a notification issued on 27th June 1969 in the exercise of the powers conferred under Section 16 of the SCRA. As the prohibition of forward trading in securities led to a decline of trade volumes on stock markets, the Stock Exchange, Mumbai (BSE), evolved in 1972 an informal system of "forward trading", which allowed carry forward between two settlement periods, which resulted in substantial increase in the turnover of the exchange. However, this has also created several problems, and there were payment crisis from time to time and frequent closure of the market. During December 1982 ­ January

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1983, the government reviewed the position and in exercise of its power under Section 10 of the SCRA, amended the bye-laws of the stock exchanges to facilitate performance of contracts in "specified securities". In pursuance of this policy the stock exchanges at Bombay, Ahemdabad and Calcutta introduced a system of trading in "specified shares" with carry forward facility after amending their bye-laws and regulations.

The Joint Parliamentary Committee on Irregularities in Securities and Banking Transactions,1992 (JPC of 1992) discussed the issue of "carry forward deals" and observed that this system was not functioning appropriately as there were a lot of irregularities in the stock exchanges in the form of non-enforcement of margins, onreporting of transactions and illegal trading outside the stock exchange. SEBI was of the view that carry forward transactions should be disallowed and transactions conducted strictly on delivery basis and trading in futures and options should be permitted in separate markets. Consequently SEBI issued a directive in December 1993 prohibiting the carry forward of transactions. However this was reviewed by SEBI, and pursuant to the recommendations of the G.S. Patel Committee to review the system, carry forward transactions in securities were permitted in 1995 subject to certain safeguards. This was further reviewed by J.R. Varma Committee report in 1997 and the system was further modified subject to a number of safeguards such as segregation of the carry forward transactions at the time of execution of trade, daily margin of 10%, 50% of which would be collected upfront, overall carry forward limit of Rs. 20 crore (CF- Conversion table) per broker per settlement and other prudential safeguards.

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Sahoo(1997) opines that on the other hand, repo transactions in government securities and public sector bonds developed during 1980s. Following the discussion of JPC of 1992, which indicated that banks found to have entered into transactions in violation of RBI circulars, RBI banned all repos except treasury bills since June 1992. The Special Court, however, declared such transactions null and void in December 1993 as being violative of the provisions of SCRA and Banking Regulation Act, 1949. The Supreme Court, however, decided in March 1997 that the ready forward contracts (Repo) were several into parts, via ready lag and forward lag. The ready lag of transactions have been completed, the forward lag, which alone was illegal had to be ignored. As repo transactions violated the Government notification of 27th June 1969 under SCRA, certain institutions such as banks, cooperative banks and other registered RBI dealers were permitted to undertake ready forward transactions in government securities through amendment notifications from time to time during second half of 1990s. The objective was to enhance liquidity market for government securities and to further develop it. There were problems with such kind of facility such as no standard documentation, "master agreement", non-use of clearing houses to undertake counter party risk and opacity of the regulatory validity in the view of the pronouncements of the Special Court and the Supreme Court. As a result the repo market was neither deep nor liquid.

This was an anomalous situation where there was a notification, which prohibited forward trading while some of forward trading (carry forward/ready forward) was prevalent. In view of changed circumstances particularly the need to develop derivatives market the repeal of 1969 notification was considered desirable not only to remove the

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existing anomaly but also as measure of market reforms. Sharpiro (2000) continues with the issue was the notification to be repealed only after amendment of SCRA so that the powers could be appropriately delegated to RBI in addition to SEBI. There were complex regulatory issues relating to repeal of the said notification and delegation of powers to SEBI and RBI. The issue was what powers in respect of which securities should be delegated to RBI, since SEBI was already exercising delegated powers under SCRA, irrespective of type of securities/transactions. The Securities Laws (Amendment) Bill, 1999 was passed (before the legislation sufficient ground work was done as would be discussed later) by the Parliament permitting a legal framework for derivatives trading in India in December 1999. Consequently, the Central Government lifted a three- decadeold prohibition on forward trading in securities on 1st March 2000. Simultaneously, in order to promote an orderly development of market; the Government issued another notification on 1st March 2000 delineating the area of responsibility between RBI and SEBI. In terms of this notification, the contract for sale and purchase of gold related securities, Government securities, money market securities and securities derived from these securities and ready forward contracts in debt securities were to be regulated by RBI. Such contracts, if executed on stock exchanges, would be regulated by SEBI in a manner that this consistent with the guidelines issued by RBI. On the same date, both SEBI and RBI issued notifications specifying the regulatory work in their respective areas. The RBI notification while retaining the general prohibition on forward trading permitted ready forward contracts by specified entities subject to certain conditions, such as, maintenance of subsidiary ledger account and a current account and such other conditions as may be prescribed. SEBI also retained the general prohibition on forward

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trading but permitted derivatives contracts as permissible under the securities law. Since both the regulators have been made responsible for regulation of debt markets, of course, with some demarcation issues of coordination become important to prevent the emergence of regulatory gaps or overlaps.

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1.3 Structure of Dissertation

Chapter 1 Introduces the subject area of the dissertation and scope of it. It places the subject area into background by briefly mentioning some of the current concerns and history concerning, derivatives in the equity market sector.

Chapter 2 This chapter looks into the markets of derivatives in detail and introduces the equity market of India and shows how derivatives revolve around the equity market. It also shows the companies which made profits through them and disasters, and, finally, why they are important in today's world.

Chapter 3 This chapter discusses the methodology of the dissertation. It describes the method of collecting data, provides an explanation of the thought behind the questions asked in the questionnaire and highlights the problems encountered.

Chapter 4 This chapter is concerned with data presentation and analysis. It commences with the presentation of data as put forward in the questionnaire, in order to facilitate in the analysis process of data. The data presented will be analysed in detail against other research. The main finding of the research is highlighted. It summarises the conclusions,

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which have been drawn using the available data and analysis of it. It also put forwards future recommendations, regarding the use of derivatives within organisations.

Chapter 5 This chapter brings out the conclusion based on the research and its findings. Area of future research has been suggested in this chapter, which has been identified during the writing of dissertation.

Thus the aims and objectives of research which have been achieved in the later part of the research and also about the historical background of derivatives market i.e. Evolution of trading and forward trading in India, has been discussed by the author in this chapter. The author in the chapter ahead is going to discuss about the in-depth knowledge of derivatives and equity derivatives.

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Chapter 2 Literature Review

Web 1 opines derivatives as "A derivative is a synthetic construction designed to give the same profile of returns as some underlying investment or transaction, without requiring the principal cash outlay. They are called derivatives because they derive their value from the performance of the underlying instrument. Financial derivatives can be found in debt, equity, currency and commodity markets". The examples of derivatives include futures, forwards, options and swaps. In simple words derivatives is a financial model which includes a wide range of financial contracts including forwards, futures, options and swaps which helps corporation to achieve success in the market. Srisha (2001) opines derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfolios risks. According to Jiwarajika (2000), "Derivatives are used as a tool of risk management; the risks are associated with derivatives including market risk, credit risk and liquidity risks. The risks are directly related to size and price volatility of the cash flows they represent they are to the size of the notional amounts on which the cash flows are based." Volker (2004) defines derivatives as "financial instruments which can be traded (e.g. options, warrants, rights, futures contract, options on futures, etc.) on various markets. They are called derivatives because they are "derived" from some real, underlying item of value (such as company share or other real, tangible commodity.) A derivative is a tradable "contract", created by exchangers and dealers. A warrant or option is the simplest form of derivative. The most common usage relates to the trading

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of commodities futures and options on futures-where pre-defined contracts relating to a right to buy or sell and underlying commodity or security are traded as opposed to the actual commodity or security itself." NPV, APT and CAPM are few such financial models which are part of derivatives; corporations use these models in addition with derivatives to achieve success. Thus, as mentioned above by diverse authors, that derivatives have various products/variants which play a vital role in the market for any institution; they are Forwards, Futures, Options and Swaps:-

2.0 (a) Forwards

Web 2 suggests that "A forward contract is an agreement between two parties calling for delivery of, and payment for, a specified quality and quantity of a commodity at a specified future date. The price may be agreed upon in advance, or determined by formula at the time of delivery or other point in time". Beside other instruments, such as Options or Futures, it is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). The forward price usually gives a good estimation of the market price in the future. D.C. Patwari and Anshul Bhargava explains in simple words that a forward contract is an agreement between two persons for the purchase and sale of a commodity or financial asset at a specified price to be delivered at a specified future date. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset at a certain future date for a certain price. The specified price is referred to as the

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delivery price. The parties to the contract mutually agree upon the contract terms like delivery price and quantity. CF ­ Appendix A

2.0 (b) Futures

Web3 opines "A Futures Contract is is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The futures price, naturally, converges towards the settlement price on the delivery date". In simple words, Web 4 opines a "futures contratct as a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Unlike options, futures convey an obligation to buy. The risk to the holder is unlimited, and because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Dollars lost and gained by each party on a futures contract are equal and opposite. In other words, a future trading is a zero-sum game. Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearing houses. Also, in order to insure that payment will occur, futures have a margin

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requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed. Hedgers often trade futures for the purpose of keeping price risk in check also called futures". Sirisha (2001) continues explaining the Types of Futures which are as follows: Foreign Exchange Futures Currency Futures Stock Index Futures Commodity Futures Interest Rate Futures CF- Appendix B

2.0 (c) Options

Web 5 opines "An Options Contract is the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option contract has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the

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upside is unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. Option contracts are most frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time risk is limited to the option premium (except when writing options for a security that is not already owned). However, the costs of trading options (including both commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In addition, options are very complex and require a great deal of observation and maintenance also called option". CF ­ Appendix C.

Hull (1995) opines that there are two different types of options which are as follows: Call Option Put Option (CF- Glossary of Terms)

Edwards (2000) critically evaluates "Asian Options are different and are average rate options. At the end of the contract period, the strike rate is compared with the average rate observed for the currency exchange. If the strike price is favorable to the holder of

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the Asian Options, the option is exercised by the way of cash settlement. Asian options are useful for hedging currency exposure where management accounts are translated on an average rate for the accounting period and are misleading cheaper that American or European options. They simply cost less because of the statistical fact that an average of a price series is more stable than any particular price series. Asian options are cash settled automatically".

2.0 (d) Swaps

Web 6 opines "A swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount. The notional amount typically does not change hands and it is simply used to calculate payments Swaps are often used to hedge certain risks, for instance interest rate risk. Another use is speculation".

The notional amount typically does not change hands and it is simply used to calculate payments.

Types of Swaps

There are two basic kinds of swaps: Currency Swaps

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Interest Rate Swaps

Edward (2000) argues that Currency Swaps involve exchange of currencies at specified exchage rates and to make a series of interest payments for the currency that is received at specified intervals.Today, interest rate swaps account for the majority of banks'swap activity and the fixed for floating rate swap is the most common interest rate swap. In such a swap one party agrees to make a floating rate interest payment in return for fixed rate interest payments from the counterparty, with the interest rate calculations based on hypothetical amouny of principal called the notional amount. CF- Appendix D

Marlowe (2000) opines that the emergence of the derivative market products most notably forwards, futures and options can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Financial markets, by the very nature can be subject to a very high degree of volatility. Through the use of the products of derivatives it is possible to fully or partially transfer risk of price by looking-in the price of assets. As instruments of risk management, derivative products generally do not influence the fluctuations in the underlying asset prices. However by locking ­in the price of assets, the products of derivatives minimize the impact of fluctuation in the price of assets on the profitability and cash flow situation of risk-averse investor.

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D.C. Patwari and Anshul Bhargava state that there are three broad categories of participants-hedgers, speculators and arbitrageurs, trade in the derivative market they are: 2.0 (e) Hedgers

Hedgers are attracted to the derivative market to reduce a risk they already face. A hedge is a position in order to offset the associated risk with the movement of price of an asset and to reduce the risk with the use of derivatives. A hedger is a trader who enters the future market to reduce a pre- existing risk.

CF- Appendix E

2.0 (f) Speculators

In contrast to hedgers who want to reduce or eliminate their risk, speculators take a position in the market, thereby increasing their own risk. Speculators buy and sell derivatives to make profit and not to reduce their risk. Speculators wish to take a position in the market by betting on future movement of price of an asset. Futures and options both increase the potential gain and losses in a speculative venture. Speculators are attracted to exchange traded derivative products because of their high leverage, high liquidity, low impact cost, low transaction cost and default risk behavior. It is the speculators who keep the market going because the bear the risks, which no one else is willing to bear. CF- Appendix F

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2.0(g) Arbitrageurs

An arbitrageur is basically risk-averse and enters into those contracts where he can earn riskless profits. It is possible to make riskless profits by buying one market and simultaneously selling in another, when markets are imperfect (long in one market and short in one market). Arbitrageurs always look out on such price differences. Arbitrageurs fetch enormous liquidity to the products, which are traded on exchanges. The liquidity in-turn results in better price discovery, lesser market manipulation and lesser cost of transaction.

CF- Appendix G

As mentioned by D.C. Patwari and Anshul Bhargava, these participants are very essential for the market in derivatives. According to Murti 2000, "the hedgers, the speculators and the arbitrageurs all three must co-exist. A hedger is always riskaverse. Typically in India he may be a treasurer in a public sector company who certainly wants to know the cost of interest for the year 2002, therefore based on the current information, he would enter into a future contract and lock up the rate of interest four years hence. But he consciously ignores what is called the upside potential (here the possibility that the interest rate may be lower in 2002 that what he had contracted for four years earlier. A hedger therefore plays it safe. To complete the hedging transaction, there must be another person willing to take advantage of the movement of price that is the

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speculator. The speculator thrives on uncertainties while the hedger avoids them. The speculator stands to gain enormously if he is proved correct but if the speculator forecast wrong then he may lose plenty of money. An integral part of derivative market is the risk taking associated with speculation. The arbitrageur is the third category of participant, who looks at riskless profit by buying and selling simultaneously, the same or similar financial products in various markets. There is a possibility to take advantage of space or time differentials that exist, as markets are seldom perfect. Arbitrage evens out the price variations.

In simple words, for healthy functioning of the derivative market, all the three types of participants are required. The market would become mere tools of gambling if without hedgers, as they provide economic substance to this market. Speculators provide depth and liquidity to the market. uniformity. Arbitrageurs help in bring price discovery and price

The presence of the three participants not only enables the smooth

functioning of the market in derivatives but also helps in increasing the market liquidity as well.

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Derivatives Markets in India

2.1 Functions of Derivative Market

According to N D Vohra & B R Bagri the derivative market performs a number of useful economic functions: 1. Price Discovery: The futures and options market serve an all important function of price discovery. To take advantage of such information in these markets, the individuals with better information and judgment are inclined to participate. The actions of the speculator swiftly feed their information into the derivative markets causing changes in the prices of derivatives, when some new information arrives, perhaps some good news about the economy. As indicated earlier, these markets are usually the first ones to react because the cost of transaction is much lower in these markets than in the spot markets. Therefore, these markets indicate what is likely to happen and thus assist in better price discovery.

2. Risk Transfer: The derivative instruments do not themselves involve risk, by the very nature. Rather, they merely distribute the risk between market participants. In this sense, the whole derivative market may be compared to a gigantic insurance company ­ providing means to hedge against adversities of unfavourable market movements in return for a premium, providing means and opportunities to those who are prepared to take risks and make money in the process.

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Derivatives Markets in India

3. Market Completion: The existence of derivative market adds to the degree of completeness of the market. When the number of independent securities or instruments is equal to the number of all possible alternative future states of economy, it implies a complete market. To understand the idea, let us recall that the derivative instruments of futures and options are instruments that provide the investor the ability to hedge against possible odds or events in the economy. If instruments may be created which can, solely or jointly, provide a cover against all the possible adverse outcomes, then a market would be said to be complete. It is held that a complete markets can be achieved only when , firstly , there is a consensus among all investors in the economy can land up with, secondly, there should exist an `efficient fund' on which simple options can be traded. Here an efficient fund implies a portfolio of basic securities that exist in the market with the property of having a unique return that exist in the market with property of having a unique return for every possible outcome, while a simple options is one whose payoffs depends on underlying return. Evidently, since the requiring condition identification and listing of all possible states of the economy can never be obtained in practice, and it is also not possible to design financial contracts that are enforceable, which can cover an endless range of contingencies, a complete market remains a theoretical concept. Thus leads to a great degree of market completeness due to the presence of futures and options.

Dhingra (2004) believes if one views that past stock exchanges and the effect of blue chip companies like IBM, Coca- Cola, Microsoft or Intel on the stock index, there is a

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Derivatives Markets in India

clear sign to the rise of stocks to substantial amounts. History shows the phenomenal growth characteristic of the above stocks is related to that of the fundamentals on which the companies have been operating under and not related to speculators. The current market capitalization of Microsoft Corporation is approximately $225 billion compared to the group turnover of mere $22 million, and looking back at the BP case study (1998), the answer indicates the advantage derivatives provide against various risk involving commodities, fixed assets or interest rate transaction and planning.

Now the question remains -Do derivatives always aid every corporation or organization to yield profits? Industry Week (July 1998) mentions that derivatives have been plagued, which have led to media's criticism and subsequent users and accounting board's cautious attitude towards derivatives. In the past most derivatives problems are related to the uncontrolled speculation by various individuals primarily in the highly susceptible futures, forwards and swaps.

Web 7 opines the difficulties with today's worldwide derivatives are as follows: It is not an investment, but a "side bet", usually very short term at that. The money is "not" put into productive use to generate an economic profit i.e. if loss it would affect the entire world and if profit, creates for the entire world. We are giving out profits not yet created to speculators who then use those profits to chase even larger amounts of future profits. We've often referred to our national debts as "hocking the futures of our children". But that is peanuts compared to the claims that the global financial bubble already has upon

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Derivatives Markets in India

mankind's future economy i.e. the profits given by the companies to the speculators are not given accurately, they are then who does the gamble in the market. The monetary profits are not being made through construction but "destruction". Stability in the markets is what is needed for development. But only through instability can the speculator make any gain i.e. Stability is derivatives' enemy. And most immediately damning to our present system is the crisis the growth in derivatives poses for the liquidity of our monetary system. In order to maintain a growing system of "robbing Peter to pay Paul", we have to have more available instruments of cash to accommodate the robbers. Far from hedging against risk as they claimed to do, "derivatives ARE the risk."

Once this process gets too far along, you are trapped into keeping the deception growing like the fellow who gets so far behind at the casino; he keeps upping the ante way beyond his means as his only hope to get back to even with the house.

Web 7 continues arguing "derivatives are the risk". This statement can be wrong at a certain point, and at the same time it can be right as well. Derivatives involving disasters have confined the notice of the global financial sector. Names like Orange County, Barings, and Proctor&Gamble have come to symbolize the "danger of derivatives". Since derivatives grow to have an increasingly significant impact in the economy of India, what does this mean for us? Barings Bank was brought down by a single trader is State Bank similarly vulnerable? Specifically in the equity market, where the first

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exchange-traded derivatives are likely to start trading in early 1998, what new pitfalls lie in store for us? Thus it shows that derivatives do not always give way to profits, but it also sometimes gives ways to losses.

Web 8 opines in fundamental nature, these examples suggest that the scandals are not only in the market of derivatives-related instruments, but also in foreign exchange trading, commodity trading and in bonds. `Over-the-counter' (OTC) deals with most of the failures which have taken place, except with the Barings' case where it was a case of internal fraud, as also with the case of Daiwa Bank, where there was a loss of $1 billion in debt portfolio. `Over-the-Counter deals lack a well laid out regulatory framework, transparency and sophisticated margin system. Due to the complex nature of transactions, most of the failure happens, while exchange-traded derivatives are simple and easy to understand. In that sense, these derivatives have been found to be more useful in allowing participants to transfer their risk, without the problems associated with the OTC deals. For normal equity or debt trading as much as derivative trading, internal control would be important in any case; and the participants need to be more cautious in implementing and operating superior back-office and control system to stay away from any internal control failures. Indian investors will have difficulties in understanding, as derivatives are complex and exotic instruments. Trading in standard derivatives such as forwards, futures and options is already established in India and has a long history. Forward-trading in rupee-dollar forward contracts, which has become a liquid market and also cross currency options trading are allowed by the Reserve Bank of India (RBI).

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The derivatives have existed in the equity market for long. In fact, the history of the Native Share and Stock Brokers Association, which is now known as the Bombay Stock Exchange (BSE), suggests that the concept of options existed early as in 1898. A quote ascribed to Mr. James P. McAllen, MP, at the time of the inaugural ceremony of BSE's new Brokers Hall in 1898, is: "....India being the original home of options, a native broker would give a few points to the brokers of the other nations in the manipulation of puts and calls."

This implies that the concept of futures and options is well-ingrained in the Indian equities market and not as alien as it is made out to be. Even today, options are traded with complex strategies, which are called jota-phatak, bhav-bhav and teji-manda (CFGlossary of terms) at various places. In that sense, derivatives are not new to India and are current in various markets including the equity markets.

Web 8 states that the market of India is not ready for derivatives trading and capital markets are safer than derivatives and are correct to some extent because there are no risks such as Investment, Liquidity, Credit, Exchange, Management and Market risks. This was the situation when they were just introduced to the market, and people playing with it didn't know what exactly it means but now derivatives are used as a tool of risk management and there are no more conflicts in using derivatives in equity markets and other markets, because people today have the exact knowledge that derivatives is not just an underlying value, because they are derived from any asset or commodity but now they

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know derivative is a financial model and know what derivatives can do to help their corporation and is far more better than capital market.

Web 9 Shah 2000 opines that ever since the first financial futures started trading in 1972, the global industry of derivatives has seen massive growth rates, with trading volumes doubling every three years for the following twenty years. The outstanding derivative position that exist today typically run into many trillion of dollars. In this situation, in the early nineties, we have seen disasters involving a few billion dollars. This is not a large "failure rate". It is useful to demarcate two categories of derivatives contracts: those which are traded at exchange and those which are traded on OTC. OTC derivatives involve many complexities: the price that is negotiated might not be fair price, there is a counter party risk, the transactions are not publicly visible and the complexity of contracts often generates unsavory sales practices and high fees for intermediaries. In contrast, exchange-traded derivatives are safer in many directions: they ensure that users get a fair price on all trades; there is zero risk of default through the role of clearing corporation and high degree of transparency. A lot of famous disasters have taken place with the OTC derivatives.

In India, on the equity market, SEBI has made it clear that the development of the derivatives industry should focus on exchange- traded derivatives. In the commodities area also, the development of the last three years in India have centered on exchanges. It is in interest rates and currencies, where OTC derivatives presently dominate in India that

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concerns about fairplay and credit risk are more serious. India's equity market has been the centre of better debates. One argument which is often heard runs as follows: "Derivatives are highly leveraged instruments; hence the proposal to create index futures and options should be viewed with great caution." This is inconsistent with a remarkable fact about exchange-traded index derivatives in India: they involve less danger than existing spot market.

Market Manipulation The index, with a market capitalisation of Rs.2.2 trillion (CF ­ Conversion table), is much harder to manipulate that individual securities. Hence the dangers of market manipulation are smaller on an index derivatives market as compared with the existing cash market i.e. the market manipulation is much smaller on an index of market of derivatives as compared to the cash market.

Insider Trading Individual companies are typified by sharp information of asymmetry, between external traders/investors and company insiders. In contrast, the index is about India's macroeconomy, where there is less information of asymmetry i.e. in this sense , there is a less scope for malpractice on a market which trades the index.

Shah 2000 continues with the India's dollar-rupee forward market experience, the largest market of derivatives in existence in India today- is an example of how this might

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proceed. When this market first came about, it had a fairly restricted usage. Today, the use of forward market is routine and commonplace amongst hundreds of importers and exporters. These are firms with core competences such as importing crude oil or exporting garments; they are faced with currency risk and do not view trading in the rupee as being a core competence. The forward market enables them to proceed with their core competences while using the forward market to eliminate currency risk. The dollar-rupee forward market has typical daily trading volumes of $1.5 billion, which makes it one of the biggest financial markets in India today. Even though it is an OTC market, it is known as a serious disaster.

Dhingra 2004 opines that over the years the market of derivatives have become multitrillion dollar markets .Derivatives are financial commitments indexed or linked in some capacity on the value of underlying assets. The bulk of the derivatives traded internationally are linked to currencies and interest rates. Other derivatives are linked to equity or equity indices. A very small volume of derivatives, compared to the total is indexed to traditional commodities. Small by comparison to other derivatives markets, these commodities-indexed derivatives markets are large compared to the underlying physical commodities markets. It has been a gradual march to glory for derivatives trading in India with current average daily trading volume at more than 10000 crores (CF-Conversion table). Thanks to the market's growing fancy for stock futures, derivatives trading have finally been able to underline its presence in the Indian capital market. From a meager Rs. 35 crores worth of turnover in June 2000, when derivatives where introduced in phase to Rs. 572,403 crores in December 2003 and reached Rs

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600,000 crore in March 2006. There has been a phenomenal rise in the growth of futures and options market. Gradually more derivatives products are being offered with the underlying as diverse as commodities, credit, interest rate, currency etc.

In simple words, derivatives have come along from 1970 till today, it had helped corporations to make immense profit, and sometimes it had corporations going down the drain with all the losses on their head. As explained earlier, derivatives have four main variants/products which are Forwards, Options, Swaps and Options and also have three main participants which are Hedgers, Speculators and Arbitrageurs and the scenario of the Indian derivative market. Now let us see how derivatives revolve around equity i.e. stock market and foreign markets in India.

2.2 Evolution of Equity derivatives and its Present Status

Shah (2000) opines equity derivatives trading started in India in June 2000, after a regulatory process which stretched over more than four years. In July 2001, the equity spot market move to rolling settlement. Thus, in 2000 and 2001 the Indian Equity market reached the logical conclusion of the reform program, which began in 1994. It is, hence, important to learn about the behaviour of the equity market in this new regime. India's experience with the launch of equity derivatives market has been extremely positive, by world standards. Amongst all emerging markets, in terms of equity derivatives turnover, NSE is now one of the prominent exchanges. There is an increasing sense that the market of equity derivatives is playing a major role in shaping price

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discovery. The goal of this section is to convey a detailed sense of the functioning of the equity derivative market. I seek to convey some insights into what is going on with the equity derivative market, and summarise broad empirical regularities about pricing and liquidity. Equity derivatives are traded only on two exchanges (CF- Glossary of Terms). NSE BSE Chart 1 shows the time-series of NSE and BSE turnover. This graph is in log scale. Straight line segments in such graphs correspond to periods of constant percentage compound growth rate. This suggests that NSE has had a phase of meteoric and steady growth from May 2001 onwards. As taken place with competing derivatives markets elsewhere in the world, there was substantial competition in the early days of market. However, NSE has become the clearly dominant market trading equity derivatives in India.

Chart 1: Derivative Markets Volume at NSE and BSE

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Derivatives Markets in India

Source: NSE and BSE The details of derivatives traded in India only on exchanges via, the BSE and NSE (Table 6). The total exchange traded derivative volume shows an increase (19.69%) to Rs.25, 641,269 million during 2004- 2005 as against Rs.21, 422,690 million during the previous year. NSE emerged as a market leader in the Indian Market by accounting for about 99.3% of the total turnover. Since more that 99% of volumes came from NSE, the further detail is based on the NSE data.

Table 6: Trade Details of Derivative Market NSE Month/ Year No BSE of Turnover (Rs. mn.) No TOTAL of Turnover No of Turnover (Rs. mn.)

Contracts Traded

Contracts (Rs. mn.) Traded

Contracts Traded

Apr-02 Apr-03 May-03 Jun-03 Jul -03 Aug-03 Sep-03 Oct-03 Nov- 03 Dec-03

804,602 2,205,470 2,252050 2,750,294 3,720,563 4,314,098 5,481,939 5,989,205 4,769,938 5,724,035

216,736 500,196 534,233 730,173 1098,495 1,403,625 1,851,509 2,303,645 1,921,714 2,389,067

1,079 5,280 1,155 423 4,718 23,634 34,274 30,668 31,337 107,545

238 873 229 92 1,031 5,090 8,509 8,574 9,287 36,840

805,681 2,210,750 2,253,205 2,750,717 3,725,281 4,337,732 5,516,213 6,019,873 4,801,580 5,831,580

216,974 501,069 534,462 730,265 1,099,526 1,408,715 1,860,018 2,312,219 1,931,001 2,425,907

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Derivatives Markets in India

Jan -04 Feb-04 Mar-04 2003-04 April-04 May-04 Jun-04 Jul-04 Aug-04 Sept-04 Oct -04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 2004-05

6,976,023 5,696,541 7,006,620

3,240,630 2,728,392 2,604,813

103,573 22,212 17,439

37,869 7,299 505 116,198 850 390 0 3 0 20,560 32,900 46,950 14,150 14,150 3,040 2,430 170,743

7,079,596 5,718,753 7,024,059

3,278,499 2,753,691 2,605,318

56,886,776 21,306,492 382,258 6,568,668 6,481,198 5,822,819 6,314,513 5,931,706 5,931,706 5,666,914 5,314,655 7,515,469 7,246,915 6,661,661 7,694,164 2,202,995 1,947,629 1,583,055 1,753,454 1,760,057 1,783,796 1,822,327 1,758,045 2,652,899 2,652,899 2,535,514 2,988,571 2,892 1,1416 0 10 0 39,788 115,298 157,458 43,942 43,942 9,213 7,070

57,269,034 21,422,690 6,571,560 6,482,344 5,822,819 6,314,523 5,978,503 5,971,494 5,782,212 5,472,113 7,290,857 7,290,371 6,670,874 7,701,234 2,203,845 1,948,019 1,583,055 1,753,457 1,706,057 1,804,356 1,855,137 1,804,995 2,667,049 2,731,745 2,538,554 2,991,001

77,017,185 25,470,526 531,719

77,548,904 25,641,269

Source: NSE and BSE Bulletin

Futures and Options Segment

Web10 opines that on June 12, 2000, the Future and Options segment commenced on NSE with S&P CNX Nifty Index Futures. Trading in options based on S&P CNX Nifty,

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Derivatives Markets in India

options on securities and futures commenced on Jun 2001, July 2001 and November 2001 respectively.

Trading Mechanism

Web10 states that the trading system of derivatives at NSE is known as NEAT-F&O trading system, which provides a fully automated screen-based trading for all kinds of products of derivatives available on NSE on a national wide basis. It supports an anonymous order driven market, which operates on a time priority/strict price. It offers great flexibility to users in terms of kinds of orders that can be placed on the system. Various time and price-related conditions like Immediate or Cancel, Limit/Market Price, Stop Loss, etc. can be built into an order. The trading in derivatives is essentially similar to that of trading of securities in the CM segment. There are four entities in the trading system:

1. Trading members: Trading members can either trade either on their own account or on behalf of their clients including participants. They are registered as members with NSE and are assigned an exclusive trading member ID. 2. Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system. These clearing members are also trading members and clear trade for themselves or/and others.

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Derivatives Markets in India

3. Professional clearing members: A professional clearing member (PCM) is a clearing member who is not a trading member. Typically, banks and custodian become PCMs and clear and settle for their trading members. 4. Participants: A participant is a client of trading members like financial

institutions. These clients may trade through multiple trading members, but settle their trades through a single clearing member only.

The terminals of trading of F&O Segment are available in 298 cities at the end of March 2006. Besides trading terminals, it can also be accessed through the internet by investors from anywhere.

Contract Specification

Web 10 Shah (2000) states that index options and index futures contracts traded on NSE are based on S&P CNX Nifty Index, CNX IT Index and the CNX Bank Index, while stock futures and options are based on individual securities. Presently stock futures and options are available on 119 securities. While stock options are American Style, Index options are European Style. There are a minimum seven strike prices, three `out-of-themoney', and one `at-the-money' and three `in -the -money'. The price at which the buyer has a right to buy or sell the underlying is the strike price. The number of strikes provided in options on Nifty index is related to the range in which previous day's closing value if Nifty index falls as per the following table:

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Derivatives Markets in India

In respect of equity derivatives, at any point the numbers of available contracts with 1 month, 2 months and 3 months to expiry are available for trading. These contracts expire on last Thursday of the expiry month. A new contract is introduced on the next trading day following expiry of the near month contract. All derivatives are never settled on credit but are presently cash settled.

Trading Value

Web 10 states that F&O segment reported a total trading value (notional) of Rs. 4824250 crores (CF- conversion table) in the previous year 2004-2005. The business growth of F&O segment is presented in Table and Chart. The trading volumes in the F&O segment indicate that futures are more popular than options; contracts on securities are more popular than those on indexes; and call options are more popular than put options. The F&O segment provides a nationwide market. Mumbai accounts for 50% of the total turnover. The share of Mumbai in total turnover has been declining over the years reinforcing nationwide presence of NSE i.e. Mumbai in India plays a major role as the turnover in November 2001 was an immense rise for the market of India.

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Derivatives Markets in India

Transaction Changes

Web 10 Dhingra (2000) states that the maximum brokerage chargeable by a trading member for the trades effected in the contracts entered on F&O segment is fixed at 2.5% of the contract value in case of index futures and stock futures. In case of index options and stock options, it is 2.5% of the notional value of the contract [(Strike Price + Premium) * Quantity)], exclusive of statutory levies. The transaction charges payable to the exchange by the trading member for the trades executed by him on the F&O segment are fixed at the rate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of Rs.1,00,000 per year. The trading members contribute to Investor Protection Fund of F&O segment at the rate of Rs. 10 per crore of turnover (0.0001%) i.e. to get the contract of NSE, the value is fixed; and the transactional charges are also fixed. The trading members are also required to pay securities transaction tax (STT) on non-delivery transactions at the rate of 0.0133% (payable by the seller) for derivatives w.e.f 1 June 2006.

Clearing and Settlement

Web10 states that NSCCL undertakes clearing and settlement of all trades executed on the F&O segment of the NSE. It also acts as legal counterpart to all trades on this segment and guarantees their financial settlement. The clearing and settlement process comprises of three main activities, viz., Clearing, Settlement and Risk Management.

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Derivatives Markets in India

Settlement Mechanism

According to Web10 Srikant and Melon (2003) "All futures and options contracts are cash settled i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. The settlement amount for a CM is netted across all their TMs/clients, across various settlements. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment".

Settlement of Futures Contracts

The future contracts settlements are of two types, the final settlement, which happens on the trading day of the futures contract and the MTM settlement, which happens on continuous basis at the end of each day.

Final Settlement for Futures

Shah (2000) states that on the day of expiry of the futures contracts, after the hours of closing of the respective futures contract on such day, NSCCL marks all positions of a CM to the final settlement price and the resulting loss/profit is cash settled. Final settlement loss/profit amount is debited/credited to the relevant CM's clearing bank account on the day following expiry day of the contract.

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Derivatives Markets in India

MTM Settlement of Futures Contracts

For each member, all contracts for futures are marked-to-market (MTM) to the daily settlement price of the relevant futures contract at the end of each day. The losses/profits are computed as the difference between: a) The trade price and the day's settlement price in respect of contracts executed during the day but not squared up. b) The previous day's settlement price and the current day' settlement price in respect of brought forward contracts. c) The selling and the buying price in respect of the contracts executed during the day are squared up.

Srikant and Menon (2003) further continues that the daily settlement price on a trading day is the closing day of the respective futures contracts on such day. The closing price for a future contract is calculated currently as the last half hour weighted average price of the contract in the F&O segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the Capital Market segment of NSE, on the last trading day of the contract. The closing price of the underlying index/security is currently its last half an hour weighted average value in the Capital Market Segment of NSE.

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Settlement of Option Contracts

The option contracts settlements are of three types: daily premium settlement, interim exercise settlement in the case of option contracts on securities and final settlement.

Daily Premium Settlement for Options

Web 10 Jhadav (2000) opines the seller of the option is entitled to receive the premium for the option sold by him. Similarly, the buyer of an option is obligated to pay the premium towards the options purchased by him. The premium payable amount and the premium receivable amount are netted to compute the net premium payable or receivable amount for each client for each option contract. The pay-in and pay-out of the premium settlement is on T+1 day. Then premium payable amount and premium receivable amount are directly credited/debited to the CMs clearing bank account.

Interim Exercise Settlement

Web10 states that Interim exercise settlement takes place only for option contracts on individual securities. An investor can exercise his in-the-money options at any time during trading hours, through his trading member. Interim exercise settlement is effected for such options at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the option contract with the same series (i.e. having the same underlying, same expiry date and same strike price), on a random basis, at the client level. The CM who has exercised the option receives the exercise 51

Derivatives Markets in India

settlement value per unit of the option from the CM who has been assigned the option contract. The interim exercise value is the difference between the strike price and the settlement price of the relevant option contract. Exercise settlement value is credited/debited to the relevant CM's clearing bank account on T+2 day (T=exercise date).

Final Exercise Settlement

Web 10 Jhadav (2000) states that final exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. All long positions at in-the-money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. Final settlement loss/profit amount for option contracts on Index is debited/credited to the relevant CM's clearing bank account on T+1 day. Final settlement loss/profit amount for option contracts on Individual Securities is debited/credited to the relevant CM's clearing bank account on T+2 day. Open positions, in option contracts, cease to exist after their expiration day.

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Risk Management System

NSCCL has developed a comprehensive risk containment mechanism for future and options (F&O) segment. The salient features of risk containment measures on F&O segment as stated by Jhadav( 2003) in his book are: The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent. NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirements for each future/options contract on a daily basis. It follows Var-based margining computed through SPAN. The CM in turn collects the initial margin from the TM's and their respective clients. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T + 1 basis. The exposure of a CM cannot exceed 33.3 times the liquid net worth for index options/futures and 20 times the liquid net worth for stock options/futures. NSCCL's online position monitoring system monitors a CMs open positions on a real-time basis. Limits are set for each CM based on his base capital. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs for MTM value violation, while TMs are monitored for contract-wise position limit violation.

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CMs are provided a trading terminal for the purpose of monitoring the open positions of all TM's clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it stops the particular TM from further trading. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in disablement of trading facility for all TMs of a CM in case of violation by the CM. A separate Settlement Guarantee Fund for this segment has been created out if the base capital of members. The fund had a balance of Rs 2500 crore (CFConversion Table) at the end of March 2006.

The most critical component of risk containment mechanism for F&O segment is the margining system and on-line positioning monitoring. The actual position monitoring and margining is carried out on-line through Parallel Risk Management System (PRISM) using SPAN(R) (Standard Portfolio Analysis of Risk) (CF ­ Glossary of terms) system for the purpose of computation of online margins, based on the parameters defined by SEBI.

NSE ­ SPAN

According to Web 11 Srithar (2000) "The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats

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futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios like extremely deep out-of-themoney short positions, inter-month risk and inter-commodity risk.

Because SPAN is used to determine performance bond requirements (margin requirements), its overriding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day based on 99% VAR methodology. SPAN considers uniqueness of option portfolios. The following factors affect the value of an option:

Underlying market price. Volatility (variability) of underlying instrument. Time to expiration. Interest rate Strike Price (CF ­ Glossary of Terms) As these factors change, the value of futures and options maintained within a portfolio also changes. Thus SPAN constructs scenarios of probable changes in underlying prices and volatilities in order to identify the largest loss a portfolio might suffer from one day to the next. Then it sets the margin requirement at a level sufficient to cover this one-day loss".

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Web 11 states that "The complex calculations (e.g. the pricing of options) in SPAN are executed by the Clearing Corporation. The results of these calculations are called Risk arrays. risk arrays, and other necessary data inputs for margin calculation are then provided to members in a file called the SPAN Risk Parameter file. This file will be provided to members on a daily basis. Members can apply the data contained in the Risk parameter files, to their specific portfolios of futures and options contracts, to determine their SPAN margin requirements. Hence members need not execute complex option pricing calculations, which would be performed by NSCCL. SPAN has the ability to estimate risk for combined futures and options portfolios, and re-value the same under various scenarios of changing market conditions".

Trading Volume and Open Interest

Web 10 states another study conducted under the NSE Research Initiative entitled "Informational Content of Trading Volume and Open Interest ­ An empirical study of Stock Market in India" examines the role of certain non-price variables namely open interest and trading volume from the stock option market in determining the price of underlying shares in the cash market. The study reveals that the open interest for stock options is one of the significant variables in determination of the future spot price of underlying share. The result clearly indicates that open interest predictions are statistically more significant than volume-based predictors in Indian context too. The results in this study show that the option markets, more specifically the net open interest, are likely to be informative about the future movement of stock prices. Investors who do

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not possess the specific information about the future price movement can use these predictors for deciding upon their trading strategies. The study reveals difference in results in US context and India maybe because firstly, the exchange traded stock derivative market in India is of recent origin; and it takes time for the investors to realise the true potential of these instruments. Secondly, the participation of institutional investors in Indian stock derivative market is extremely limited. It can be attributed to the regulatory restrictions where in such investors are allowed to use derivative securities for the purpose of hedging only. The story of mutual funds is not significantly different from this. Therefore, the investors who have better access to information and can be classified in the category of informed investors are constrained to deal in the derivative securities. Though there are some positive developments taking place in this direction, these securities are yet to gain significance in the portfolio of institutional investors in India.

Settlement

All derivatives are currently cash settled. During 2004-2005, the cash settled amounted to Rs.145,4816.15 million. The futures and options settlement involved Rs.132,516.81 million and Rs.13,969.34 million, respectively. The settlement details on F&O segment are presented below.

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Derivatives Markets in India

Table 7: Settlement Statistics in F&O Segment ( In Rs.mn) Month / Year Index / Stock Futures Index / Stock Options Total

MTM

Final

Premium Exercise

Settlement Settlement Settlement Settlement

2000-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 2001-02

840.84 80.43 37.76 48.52 66.95 45.94 336.87 112.69 283.75 789.41 1125.28 1088.7 1036.18 5052.48

19.29 0.88 1.13 0.1 1.35 1.36 5 1.01 7.09 37.62 21.69 122.14 19.88 219.25 14.69 58.76 98.31 156.22 179.61 245.55 174.67 305.71 244 170.08 1647.6 2.75 14.28 50.62 139.09 114.22 202.14 82.14 177.55 88.57 68.1 939.46

860.13 81.31 38.89 66.06 141.34 196.23 637.18 407.53 738.53 1083.84 1630.23 1543.41 1294.24 7858.79

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Derivatives Markets in India

Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 2002-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03

1065.6 1665.4 1240.5 1608.8 1021 1198.3 1282.4 1109.3 1640.4 2184.19 1484.2 1878.93 17379.02 2058.06 1635.92 2202.33 3897.88 5696.01 10318.74 11880.49 9393.49 9054.58

41.5 18.4 34.4 17 28.8 14.4 77.9 86.8 53.3 29.92 16.8 38.38 457.6 47.93 57.42 38.58 80.24 85.82 92.38 141.09 238.6 178.99

173 215.3 197 236 204.6 233.1 258 337.1 446.4 383.92 289.3 338.39 3312.11 459.95 380.39 487.81 694.32 773.16 781.23 991.48 634 699.91

86.5 143.5 103.5 106.7 138.9 134.6 166.4 353.4 168.2 229.38 131.4 196.35 1958.83 300.07 304.3 464.99 447.68 588.14 304.09 603.07 221.13 410.95

1366.6 2042.6 1575.4 1968.5 1393.3 1580.4 1784.7 1886.6 2308.3 2827.41 1921.7 2452.05 23107.56 2866.01 2378.03 3193.71 5120.12 7143.13 11496.44 13616.13 10487.22 10344.43

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Derivatives Markets in India

Jan-04 Feb-04 Mar-04 2003-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 2004-05

26682.05 13296.98 12103.23

128.24 164 136.18

1074.58 682.56 930 8589.39 647.04 912.9 468.1 721.3 509 562.1 685 768.2 1040.9 963.6 963.5 1169 9410.64

426.73 244.2 445.84 4761.19 252.9 358.2 98.5 427.7 146.5 397.4 310 419.5 565.4 423.7 393 765.9 4558.7

28311.6 14387.74 13615.25 122959.8 9429.45 26967.1 6119.6 5811.9 6222.4 5887 9605 8201.5 14215.2 24881.6 11379 17766.6 146486.4

108219.76 1389.47 8372.79 25561.3 5352.5 4511.5 5480.1 4801.2 8378.2 6911.7 12385.8 23176.9 9916.3 15393.5 156.72 134.7 200.5 151.4 86.8 126.3 231.8 102.1 223.1 317.4 106.2 438.2

130241.79 2275.22

Source: NSE (CF- Conversion Table)

Member Concentration

In recent months, there had been a great deal of concern about the sharp concentration of the market turnover in derivatives and positions amongst a very small set of brokerage

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Derivatives Markets in India

firms. The trading patterns of members in the Derivative Segment are shown in the Table 3. The top ten members are vital in the case of options which perhaps reflect the greater demands upon IT system, and human capital of the preceding years was more usable directly.

Many brokerage firms made a business decision that the derivative market was unlikely to succeed when the market was young. This gave huge success to the brokerage firms who were equipped with the vision to anticipate the success of this market and invest in IT and human capital. These pioneering firms are perhaps expected to have the first dominant market share. Over time, as other brokerage start building activities of derivatives, it is expected that these numbers will be substantially transformed.

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Table 3: Member Trading Pattern in the Derivative Segment

Month

No Of Members May 06 Jun 06 43 85 181 97 103 208

Upto to Rs. 100 mn Rs. 100 mn. Up to Rs. 500mn. Rs. 500 mn. Up to Rs. 2500mn. Rs. 2500 mn. Up to Rs. 5000mn. Rs.5000mn Upto Rs.10000mn Rs. 10000mn and more Source: NSE

32 58 175 96 101 252

From this section we have known what exactly derivatives means i.e. its products, participants, functions and disasters which it had caused to some MNCs and at the same time were used by Coca Cola, etc to make profits for their organisation. Derivatives is a risk for every organisations as mentioned earlier; because, if not used in the right manner it would cause tremendous losses to companies using it. The evolution of equity

derivatives is also mentioned in this section, showing how derivatives are essentially important in the equity market. In the chapter ahead the author will discuss the methodology i.e. how the data was collected and what hindrances were there while collecting the data for this research.

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Chapter 3

Research Methodology

Web12 defines research as "a systematic investigation, including research development, testing and evaluation, designed to develop or contribute to generalizable knowledge. Activities which meet this definition constitute research for purposes of this policy, whether or not they are conducted or supported under a program which is considered research for other purposes. For example, some demonstration and service programs may include research activities"

3.0 Introduction

According to Cassel, C. & Symon, G., (2004), all research involves data collection and analysis, whether through observation, reading, measurement, asking question or a combination of these or other strategies. The collection of the data and for research may, however vary considerably in its characteristics. In simple words research can be primary or secondary. In primary research the collection of data is specifically for study at hand. It can be obtained by communicating directly or indirectly with the subject or directly by the investigator. Qualitative research and quantitative research are included in the direct communication techniques. For the purpose of this research, a combination of primary and secondary data have been used; and, under primary, although largely quantitative data was collected, room for qualitative data was made available whenever thought necessary.

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3.1 Methods of Collection of Data

Flower (1985) opines the choice of collection of data mode-mail, personal interview, group administration, or telephone is directly related to the sample frame, research topic, characteristics of sample and the resources available; it has implication of rates of response, question form, and survey costs. As mentioned earlier, that there are two main researches which are primary and secondary research:

3.1 (a) Primary Research

Web 13 suggests that primary research is conducting original research to obtain a variety of social indicators that can help to determine the risk of community and protective factors identify community resources, and determine community readiness for prevention efforts. For instance primary research can involve researching community laws and surveys to determine norms, gaps, attitudes or social services. Some methods of conducting primary research are as follows: Questionnaires Experimentation Observation Documentary Sources

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Derivatives Markets in India

3.1 (a) (I) Questionnaires

According to Cassel, C. & Symon, G., (2004), questionnaires are as a low-priced way to gather information from a potentially large number of respondents. They are often the only feasible way to reach a number of reviewers large enough to statistically allow analysis of results. It can gather information on both the information on specific components of the system as well on the overall performance of the test system, if a welldesigned questionnaire is used effectively. They can be used to correlate performance and satisfaction with the test system among different group of users, if the questionnaire includes demographic questions on the participants. In simple words questionnaires are an economic way of collecting data from a large number of participants. Questionnaires are the most important research techniques and ways of collecting data. When a questionnaire is administered, the researcher control over the environment is somewhat limited.

Web 14 opines the steps which are required to design and administer a questionnaire include: Defining the Objective of the Survey Determining the Sampling Group Writing the Questionnaire Administering the Questionnaire Interpretation of the Results

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Questions may be designed to collect either quantitative or qualitative data. Quantitative questions are more precise then qualitative, by the very nature. The qualitative questions may cause the participant to become bored with the questionnaire sooner as it requires more thought on the part of the participant. In general it can be said that questionnaires can measure both quantitative and qualitative data well but that qualitative questions require more care in design, administration and interpretation. Denzin, N.K. & Lincoln, Y.S. (2000) opines that questionnaire can be open-ended and close-ended i.e. coded, the former does not restrict the participant's answers and the later provides a number of coded options. Their respective merit depends on the aims of the study and the needs of the analysis. If desired, the results of open ended questions can be coded into different categories so that an account of various response is available, though qualitative information might be lost in doing so.

Web 14 continues by stating that a design of a questionnaire should take into consideration the present beliefs, depth of knowledge for the product, attitudes and perceptions, of the respondents. It should be free of bias, use simple languages to understand and the questions asked should not lead the respondent to a particular answer. There are some key features to design a questionnaire, although there is no perfect way to do it. According to Oppenheim (2000), there are 5 basic types of questionnaires. In- House Survey Telephone Mail Questionnaire

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Derivatives Markets in India

Computer Questionnaire Mall Intercept In this particular instance a simple questionnaire method was adopted to collect data for analysis because of several reasons. Questionnaires are an inexpensive way of gathering data from a potentially large number of respondents who are spread out. It was an appropriate way to reach a number of reviewers large enough to allow the result analysis. The questionnaire is designed to gather quantitative data largely; however, it does have questions that require qualitative answers. This is done with an intention to gather reliable data as much, as possible, incorporating qualitative question only when thought to be essential. More importantly, under this instance, an all qualitative questionnaire would lead to excessive indulgence in thought thereby leading to waste of time and boredom and therefore inaccurate answers. At the same time various casual discussions were conducted on the subject to generally get a vibe on their experience and opinions before designing the questionnaire.

3.1 (a) (II) Experimentation

Donald S.Tull and Deli. I .Hawkins (1993) define as "A controlled situation in which the experimenter systematically changes the values of one or more variable (independent variables) to measure the impact of these variables (the dependant variables)". Those items that are affected by the experimental treatment are the dependant variables.

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3.1 (a) (III)

Interviews

Denzin, N.K. & Lincoln, Y.S. (2000) opines that the method of interview involves discussing or questioning issues with people. For the collection of data, it is a useful technique which would be unlikely to be accessible using techniques such as observation or questionnaires. An interview normally tends to have a social character. Interviews may, however, be time consuming as the right respondent might not always be available and can also be costly. An important contribution of interviews perhaps stems from its flexibility. It, in most cases, helps in building a relationship; thereby allowing for better collection of data.

3.1 (a) (IV)

Documentary Sources

It is possible to gain information from other sources for special use or to complement questionnaires, although a great deal of data on individual is confidential. At the commencement of research, it can prove valuable to look at documentary sources. It is basically a review of papers and this can involve: Articles from previous publications Sites on internet Documents on audio, video or a computer supported mechanism Advisors with a particular expertise

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The purpose of reviewing the documents is to allow for a better idea about what has been said and written on the subject under study.

3.1 (b) Secondary Research

Web15 defines secondary research as "data which already exist in some form, having been collected for a different purpose, perhaps even by a different organization, and which might be useful in solving a current problem". Although secondary research less expensive than primary research, it is not always accurate, useful, as specific, custommade research. There are various sources available to the marketer, and the following list is by no means conclusive: Census data Public records Business libraries Trade directories Trade Associations Websites Omnibus surveys Published company accounts Previously gathered marketing research Informal contracts National/ International governments Professional institutes and organizations

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Derivatives Markets in India

National and local press Industry magazines

Types of Secondary data include: There are basically two types of research of research methods, qualitative and quantitative. Silverman (2000) opines that the danger in the title, however, is it seems to assume a fixed preference or pre-defined evaluation of what is good (i.e. qualitative) and bad (i.e. quantitative) research.

3.1 (b) (I) Qualitative Research

Web 16 defines "Qualitative research is a generic term for investigative methodologies described as ethnographic, naturalistic, anthropological, field, or participant observer research. It emphasizes the importance of looking at variables in the natural setting in which they are found. Interaction between variables is important. Detailed data is gathered through open-ended questions that provide direct quotations. The interviewer is an integral part of the investigation (Jacob, 1988)".

Silverman (2000) states that the reason for these differences lies in the purpose of the research. Qualitative research is designed to predict and control the topic of study. Therefore, the quantitative researcher must be able to predict and control the data they are gathering.

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3.1 (b) (II) Quantitative Research defines "Quantitative research is the systematic scientific investigation of

(Web 17)

quantitative properties and phenomena and their relationships. Quantitative research is widely used in both the natural and social sciences, including physics, biology, psychology, sociology, geology, education, and journalism. The objective of quantitative research is to develop and employ mathematical models, theories and hypotheses pertaining to natural phenomena. The process of measurement is central to quantitative research because it provides the fundamental connection between empirical observation and mathematical expression of quantitative relationships.The term quantitative research is most often used in the social sciences in contrast to qualitative research".

Motley (1986) citicises studies for lacking a strong theoritical basis from which to operate. However, quantitative researchers fail to acknowledge is the position they put themselves in when they do this. Silverman (2000) opines that much quantitative

research leads to the use of a set of adhoc procedure to define, count and analyse its variable. The main advantage of quantitative research method is that it gives out quantifiable data sometimes, which needs to be generalised. The great weakness of this approach is that it does not take account of human behaviour, but it is important to find out the actual objectives of the reseach.

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According to Hathaway (1995), another major difference between that the two is the underlying assumptions about the researcher's role. In qualitative research, it is the thought that the researcher can learn about situtation mostly by participating or/and being immersed in it. In quantitative research, however, the research is ideally an objective observer that neither influeces or participates in what is being studied. The basic underlying assumptions of both methodologies guide and sequence the types of data collected methods employed. The primary research in this instance was largely based on quantitative analysis.

3.2 Research Process

Web 18 states that "The research process is the step-by-step procedure of developing one's research -- and research paper. However, one can seldom progress in a step-by-step fashion as such. It is often necessary to revise an initial research plan. The research process involves identifying, locating, assessing, analyzing, and then developing and expressing your ideas. These are the same skills that will be needed in the post-university "real world" when you produce reports, proposals, or other research for your employer. All of these activities will be based on primary and secondary sources from which recommendations or plans are formulated". There is no fixed number of stages to be followed since it varies from research to research. At the same time every research process does in reality follow a common trend in its completion. This includes

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formulating and clarifying a topic, reviewing the literature, choosing a strategy, collecting the data, analysing the data collected and finally writing up.

Naresh K. Malhotra (2004) opines the different steps in which research should be done. Problem Definition. Development of an Approach to the Problem. Research Design Formulation Field Work or Data Collection Data Preparation and Analysis Report Preparation and Presentation.

Web19 states the different steps in research in a more simple understandable way in which research should be done.

Define the Problem How is the collection of data done to analyze problem to be solved? Select the method of sampling How will be analyzing any collection of data. The decision about the budget and time frame is to be done. Go back and speak with the clients or managers requesting the research. Make sure that you agree on the problem. If you gain approval, then move on to the next step. Go ahead for the collection of data.

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Conduct data analysis. Check for the errors. It is not uncommon to find errors in sampling, method of collecting data, or analytic mistakes. Write your final report.

3.3 Research Design

Naresh K. Malhotra (2004) opines that research design is a blueprint or framework for conducting the research project. It is in simple words, a plan for study that guides the collection and analysis of data. It, in fact, is the central part of any activity involving any work of research. It serves as a guide to the investigation methods, the instruments in research used, nature of data with the sampling frame and plan. One of its key features should be to hold the parts and phases of the enquiry together. It should be comprehensive in its coverage of the work i.e. it should allow for logic, tight-ness, precision, and effective use of resources. A research design lays the foundation for conducting the project. A good research design will ensure that the research plan is conducted efficiently and effectively.

3.4 Sampling

Four companies were chosen for having Comparative Analysis of Current and Future trends with the help of Equity (stock) market in India.

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The companies which have been chosen for the comparative study are: NSE BSE ShreeKrishna Mutual Funds Ltd Kabra Mutual Funds Ltd.

These above mentioned companies do represent a part of Mutual Fund's Associations companies, so data collected is valid and reliable to all extent.

The author in his Research will be carefully studying, analysing, and would make conclusions on the overall performance of three kinds of funds of the above chosen Mutual Fund Companies.

In addition to these the author would conduct interview with the Director of Kabra Mutual Funds Ltd, ShreeKrishna Mutual Funds Ltd, Mr. Nikunj Shah - Dealer Institutional Derivatives, Mr. Chirag Mehta - Dealer Institutional Derivatives on how an investor would choose the right kind of equity and a brief view of working of the market of derivatives in India.

3.5 Questionnaire Design

A Mixed Method Approach was used by the author to segment the questionnaires. Quantitative data was supposed to be used; but to get certain definite answers to

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certain questions, qualitative data analysis was used. The questionnaire was designed largely to gather quantitative data, although it does have questions that require qualitative answers. This is done with an intention of collecting as much reliable data as possible incorporating qualitative questions only when thought necessary. As mentioned earlier, to generate `Important Questions', the research will use qualitative research methods. Since the range of responses were not tightly defined in coded questions, open format questions have here felt good for soliciting subjective data. An obvious advantage is that the variety of responses should be wider and more truly reflect the opinions of the respondents. Therefore, an open-ended question with a coded system was used to collect data so that while a definitive answer is gauged, room for personal expression is not lost in the process. A logical sequence was followed allowing for test of bias mechanism in it, while designing the questionnaire. The length of the questions was of paramount importance, because it was tempting to ask long, explanatory questions to the interviewee; but since that could lead them on to the answer, a right balance needed to be struck. So most of the questions were kept short and brief, but an odd question was allowed to be long if required as it was felt useful to give the respondents time to marshal their thoughts if that meant a more certain answer. Finally, having taken into consideration the most essential feature was to ensure that the questions were simple, clear, avoiding hypothetical questions, were not leading, and uses correct language and phrasing.

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3.6 The Interviews

The data that is collected is valid and reliable as mentioned earlier as these companies represent a part of Mutual Fund's Association of the companies. Therefore, same set of questionnaires were used but subsidiaries' questions were used depending on the responses. Therefore, various interview will be conducted i.e. interviewing the Managing Director of Kabra Mutual Funds Ltd, ShreeKrishna Mutual Funds Ltd, Mr. Nikunj Shah - Dealer Institutional Derivatives, Mr. Chirag Mehta - Dealer Institutional Derivatives Ltd and some interviews with the employee working for the above mentioned firms and the employees of NSE and BSE markets. The sample size of interview will be 15- 30 which would be analysed by quantitative methods. To collect the data from the four major mutual fund companies under study, the researcher has used semi-structured interviews. The data that is collected is recorded as written note and shown in chart form analysis. The real motives and feelings were obtained from the respondents with the help of interviews. The bias information is removed through this process and tries to probe deeply into real ideas of the respondents. The questionnaire was easily understood by the respondents and the answers were given readily. Generally, the researcher found that the questions followed from the answers provided the interviewees leading too much in-depth discussion later.

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3.7

Conclusion

For this research, the purpose is to analyse quantifying behaviour, for which a questionnaire model of collecting data will be the most suitable. For gathering responses from a carefully crafted cross section of the general public via the internet using email for delivering and receiving responses, a self-administered questionnaire was used. The data gathered will help in ascertaining the main reasons for difficulty faced by major entertainment companies in breaking into some consumer markets. Provision for qualitative responses will be made by the questionnaire, for respondents to express their views on issues directly related to the study which will in the end be used to come to a conclusion on the over all hypothesis of the research which is to say that there seems to be a strong cultural resistance in some regions faced by major organisations in the industry when trying to win over audience. The validity and reliability of the collection of data helps in better quality research.

Thus, in this chapter the author has discussed the meaning of research and classification of primary and secondary research i.e. Qualitative and Quantitative research, the process of research and the design in which the author has structured i.e. Sampling , Questionnaires and Interviews. In the chapter ahead author has discussed the analysis of data and its findings.

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Chapter 4 Data Analysis and Findings

Derivatives are key parts of the financial system. They are financial instruments which are derived from underlying items of values and it does play a vital role in the equity markets in many forms such as Forwards, Futures, Swaps and Options. Derivatives do revolve around these above-mentioned variants/products with the help of its participants which are Hedgers, Speculators and Arbitrageurs. Chart 1: Awareness of Derivatives in Equity Market.

100 80 60 40 20 0

95

Yes N o N /A

41

The chart above clearly shows that 95% of the people have knowledge about what derivatives are and how they revolve around the equity market. 4% of the people thinks that derivatives are no longer to be used in the equity market, and 1% of the people has knowledge of what derivatives are but do not know what difference it makes to the equity market.

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The NSE reported a total turnover of Rs.25, 470,526 million (CF- Conversion Table) during 2004-2005 as against Rs.21,306,492 million during the preceding year, about 770 lakhs contracts were traded during the same period. The daily turnover average also increased from 110,150 million in April 2004 to 135,844 million in March 2005.

The product-wise distribution of turnover for NSE segment for the period 2004-2005 is presented in Chart 2. It seems that near month contracts are most popular than not so near month contracts, futures are more well-liked than options, contracts on securities are more well-liked than on indices and call options are more well-liked than put options.

Chart

2

Product-wise

Distribution

of

Turnover

of

NSE,

2004-2005

Thus from the above chart we can see clearly that Stock Futures (58.27%) have dominated the market in 2004-2005 and have the highest product-wise distribution of

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turnover of the NSE in compared to Stock Options(6.63%), Index Futures (30.32%) and Index Options(4.79%).

One of the puzzles in India's experience with the equity derivatives has been domination of individual stock derivatives. This partly reflects a problem with human capital, where the thought processes of speculation and market making on individual stocks, which have prevailed for many decades, were carried forward into equity derivatives market from 2001, onwards. In contrast, trading in index derivatives requires new kinds of thinking like the portfolio concept diversification.

As experience with derivative grows, we shall expect a greater shift away from individual stocks to index derivatives. In addition, the importance of index volatility is greater when faced with situations like budget announcement, or the Gulf War, as opposed to months where macroeconomic news appears to be unimportant.

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Chart 3: Business Growth of NSE Segment

Source: NSE

The business growth of NSE segment is shown in the chart above. The daily average turnover is also shown during the period. It is seen that the average daily turnover was more than 250000 million (conversion table) during Jan-Mar 2006 quarter whereas it has been increasing from Jan- Mar 02 quarter which was approximate 1000 million, it does not mean that people didn't know what was the equity market at that time but they were getting much more knowledge about the stock market and thus as we can see in the chart above the business growth have not been stagnant but it has been increasing with a quick speed and thus have reached the turnover above 250,000million during the quarter Jan ­ March 2006.

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Intermediation

The key element of a successful derivatives market is a nationwide network of brokerage firms. These role play a important role in terms of giving direct market access to firms and individuals located across the country , by doing credit risk management about the failure of customers, and by performing knowledge functions in terms of training, technical support and consulting. This network of firms has been a key element in the nationwide outreach of the modern securities industry, as opposed to the traditional south Bombay focus which prevailed prior to 1994.

Geographical Distribution

The F&O segment of NSE (CF- Glossary of terms) provides a nation-wide market. In the chart below the city-wise turnover of the F&O segment is presented in the Table. During the month Jan 2005, Mumbai contributed nearly 43.54% of the total turnover. The contribution from Delhi was 21.54% and Kolkata was 12.15%. Table1 shows the distribution of and the turnover of derivatives by various urban centres as of Jan 2005. This shows that equity derivatives trading is more concentrated in the top five urban centres. Turnover from outside the top five centres amounts to 18.2% only. This difference is likely to be largely owing to gaps in knowledge on the part of employees of brokerage firms, and their customers, in location outside the major urban centres.

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Member trading Pattern in the Derivative Segment

Source: NSE

Open Interest

Open Interest is the total number of outstanding contracts that are held by market participants at the end of each day. Putting it simply, open interest is a measure of how much interest is there is a particular option or future. Increasing open interest means that

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fresh funds are flowing in the market, while declining open interest means that the market is liquidating.

Chart 4: Awareness of the Open Interest Rate

120% 100% 80% 60% 40% 20% 0% Yes No N/A 2% 1% 97% Yes No N/A

Chart 4 clearly shows that 97% of the people are aware of what is open interest and have knowledge about how important is it for the equity market., where as 2% of the people do not know what is implied by open interest rate and 1% are aware and have knowledge about how important is open interest rate but they don't know what difference does it make to the equity market.

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Chart 5: Daily Open Interest for Near Month Nifty Futures for 2004 - 2005

Source: NSE

Chart 5 clearly shows that the daily open interest rate have been tremendously going up from 1- 15 April 2002 which is a very good sign for market, because the more the open interest goes up, the more the market is flowing in with fresh funds and by any chance if the daily open interest rate goes declines/down, then the market will have to pay debts. So, the above chart clearly shows that the market is flowing in with fresh funds and the daily open interest rate is as high approximate Rs.20000 million.

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Implied Interest Rate

Avadhani (2000) believes in the ideal efficient market, the cost of transaction should be zero, and there should be a generous supply of sophisticated arbitrageurs. This should yield a cost of carry on the futures market which exactly reflects the zero coupon yield curve for government bonds, with a slight risk premium to reflect the failure probability of clearing corporation.

The implied interest rate or futures market or cost of carry is often used inter-changeably. Cost of carry is more appropriately used for commodity futures, as by definition it means that the total costs required carrying a commodity or any other good forward in time. The costs involved are insurance cost, transportation cost, storage cost and the financing cost. In case of equity, the carry cost is the cost of financing less the dividend returns. Assuming zero dividends the only relevant factor is the cost of financing. One could work out the implied interest rate incorporated in future prices, which is the percentage difference between the future value of an index and the spot value annualised on the basis of the number of days before the expiry of the contract. Carry cost or implied interest rate plays an important role in determining the price differential between the spot and the futures market. By comparing the implied interest rate and the existing interest rate level, one can determine the relative cost of futures' market price. Implied interest rate is also a measure of profitability of an arbitrage position. Theoretically, if futures price is less that the spot price plus cost of carry or if the future price is greater than the spot price plus cost of carry, arbitrage opportunities exist.

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Chart 6 shows the awareness of people in subject to Implied Interest Rate. The futures prices are available for different contracts at different points of time. Chart 7 presents Nifty futures close prices for the near month contracts, which are most liquid and the spot Nifty close values from April 2003 to March 2004. The difference between the future price and spot price is called basis. As the time to expiration of a contract reduces, the basis reduces. Daily implied interest rate for Nifty futures from April 2003 to March 2004 is presented in Chart 8. The implied interest rate for near month Nifty Futures as on the last trading of the month is presented in Table 2. It is observed that index futures market suffers from mispricing in the sense that futures trade at discount to underlying. This may be due to restriction on short sales and lack of maturity. Chart 6: Awareness of Implied Interest rate

100% 96% 80% 60% 40% 20% 0% Yes 3% N o 1% N /A Yes N o N /A

Chart 6 above shows that 96% of the people are aware of what implied interest is and have the knowledge about how important it is to the equity market, where as 3%of the people have no clue about what is known by implied interest rate and 1% of the people

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are aware of it and have knowledge about how important is Implied interest for the equity market but they don't know what differences does it make to equity market.

Chart 7: Nifty Futures and Spot Price (2004 -2005)

Source: NSE

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Chart 8: Implied Interest Rate for Near Month Nifty Futures (April 2004-March 2005)

Source: NSE

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Table 2: Implied Interest Rate for Near Month Nifty Future

Source: NSE

Implied Volatility

Web 10 opines that volatility is one of the important factors, which is taken into account while pricing options. It is a measure of the amount and the speed of price change. To estimate future volatility, a time series analysis of historical volatility may be carried out to know the future movements of the underlying. Alternatively, one could work out implied volatility by entering all parameters into an option pricing model and then solving it for volatility. For example, the Black Scholes model solves for the fair price of

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the option by using the following parameters-days to expiry, strike price, spot price, and volatility of underlying, interest rate, and dividend. This model could be used in reverse to arrive at implied volatility by putting the current price of the option prevailing in the market. Putting it simply implied volatility is the estimate of how volatile the underlying will be from the present until the currency of option. If volatility is high, then the options premiums are relatively expensive and vice-versa. However, implied volatility estimate can be biased, especially if they are based upon options that are thinly traded samples.

Chart 9: Awareness of Implied Volatility

100% 95% 80% 60% 40% 20% 0% Yes 3% No 2% N/A Yes No N/a

Chart 9 above shows that 95% of the people are aware of what Implied Volatility is and have the knowledge about how important it is to the equity market, where as 3%of the people have no clue about what is known by implied volatility and 1% of the people are aware of it and have knowledge about how important is Implied Volatility for the equity market but they don't know what differences does it make to equity market.

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Chart 10: Intra-day evolution of Implied Volatility

Chart 10 shows the time-series of implied volatility on the two most traded underlying ­ Satyam Computer and Nifty ­ on 9 December 2002. The upper curve in the graph is obviously that for Satyam, and the lower one is for Nifty. This graph plots the implied volatility associated with the price observed on every trade for ATM call or put options. The range of values seen in this graph, even at a single point in time, reflect (1) the bid/offer spread on both call and put option markets, i.e. the "bid ask bounce", and (2) the lack of put-call parity arbitrage, through which call and put options do not trade at 93

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identical implied volatilities. A casual perusal of the graph seems to suggest that there is a good deal of potential for intra-day trading on the options market. The derivatives market is producing new information in the Indian economy, by making available these marketbased volatility forecasts (Bodie & Merton 1995). As option liquidity builds up, we will be able to obtain a term structure of volatility, showing market forecasts of volatility between the trading day and various different expiration dates. Such interpretations, and uses of implied volatility, will be much more justifiable after put-call parity is established by arbitrageurs, whereby put and call options will show near-identical implied volatilities. Prof. J. R. Varma ("Mispricing of Volatility in the India Index Options Market", Working Paper 2002-04-01, April 2002, IIM, Ahmedabad) has estimated the option prices and implied volatility from the Black formula. It was found that for about 6.5% of all calls and about 7.5% of all puts, implied volatility was undefined, because the option traded below its intrinsic value. This is an indication of mispricing of options.

A study conducted under the NSE Research Institute titled "Futures Trading, Information and Spot Volatility of NSE -50 Index Contract," Working Paper No. 18; November 2002 in particular addressed the impact of introduction of futures trading on volatility of spot market by separating the possible effects of market wide information. The changes in the volatility of spot price may be due to other factors apart from futures. The study reveals that there is a fall in volatility since the commencement of futures trading which may be attributed to increase trading in the cash markets due to faster dissemination of information making cash markets more liquid and therefore less volatile. It could be also due to shift of speculation from cash market to futures market due to low transaction

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costs and high leveraging in the futures market. This shift can be attributed to low margins, low transaction cost and standardised contracts and trading conditions prevalent in the futures market.

Volatility Smile

Avadhani (2000) proposes that volatility smile is the relation between implied volatility and the strike price of the same maturity. Normally the smiles for equity options have a downward sloping curve and they look alike for both put and call option. However, in Prof Varma's "Mispricing of Volatility in the Index Options Market" working paper 2002-04-01, April 2002, IIM, Ahemdabad found V shaped smiles and the smiles are markedly different for puts and calls. He estimated volatility smiles separately for puts and call options and established that the smiles are sharply different for calls and puts. The implied probability distribution is more highly peaked and has (expect for deep-inthe money calls) thinner tails than normal distribution or historical distribution. The market thus appears to be underestimating the probability of market movements in either direction. Prof. Varma also noticed some over pricing of deep-in the-money calls and some inconclusive evidence of violation of put-call parity. However, it was observed that the observed prices are rather close to the average of the intrinsic value of the option and its Black-Scholes value disregarding the smiles. In an ideal Black/Scholes world, the market should use a single implied volatility in pricing options for a given maturity, with various different strikes. However, in the real world, the phenomenon of the `the

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volatility smile' has been repeatedly observed. This is depicted pictorially in a graph where option strikes are placed on the x-axis, and implied volatilities placed on the y axis. The figure often looks like a "smile", with higher implied volatility for strikes which are far away from the spot price. The smile is generally interpreted as evidence that the simple Black/Scholes model does not fully capture the behaviour of the market.

Chart 11: Volatility Smile for Nifty at 3 PM on 9th Dec 2002

Chart 11, above shows a typical smile diagram for Nifty and Figure 1 shows the diagram for a few stocks. We do see significant variation of the implied volatility depending on the stock price. However, there is no simple, `smile pattern'. It is striking to see a greater flatness of the smile when the bid/offer spread is tight, i.e. when there is a greater 96

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liquidity. There may be an underlying phenomenon where higher implied volatilities and high bid/offer spreads are both reflecting underlying uncertainty in the market.

Figure 1: Volatility Smile for four underlying at 3 PM on 9th Dec 2002.

From the above Figure 1, it can be seen clearly from the above findings that derivatives are important tool for the equity market and they do play an important role in the upbringing of the market as well. But how these analyses/findings ahead are compared to see their relevancy with the help of STEEPLE analysis previously called as PESTEL Analysis. It is however, useful to begin with the process with a checklist ­ Political Future, Environmental Future, Economic Future, and Social-Cultural Future,

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Technological Future, Legal Future and Educational Future. In the STEEPLE Analysis the only factor which will not be compared to check the relevancy of the equity market in Environmental Future. The chart below presents some of the main item that might be considered when undertaking a STEEPLE Analysis to compare the relevancy of equity market in any country.

Political Future

Relation between the organisation and government

The distribution of income is directly related to GDP of a country, as mentioned above and since the GDP is directly related to each and every consumer's income, therefore more than 79% of the people are employed by the equity market and thus it concludes that India is a tertiary economy and no more an agrarian economy. Nowdays, the government is playing a major role in each and every country and giving out investment policies not only related to stock market but also related to power sector industries, tea industries etc.

Government ownership of industry and attitude to monopolies and competition Government ownership of industry and attitude to monopolies and competition over certain firm shares i.e. stocks and in certain firm's government have got up to 25% stack in their annual earnings to support the infrastructure of the country.

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Education Future

Today there is an awareness made to the people by the government that the fact that derivatives do play an important role in the equity market by making them more and more educated not in general manners but also in the stock market, to know how vital the stock market is, there are courses conducted. And how our economic is directly related to it, which is very vital for all the individuals to know, because the total GDP for our country depends on the equity market.

Economic Future

Interest Rate

Interest rate depend on the equity market because if the interest rates are set high by any firm for their shares then buyers would not buy their shares and would opt for some other good firm's shares i.e. stocks. So the interest rate for each and every firm's shares should be set to standard rate.

Investment, by the state, private enterprise and foreign companies.

There is investment made by foreign companies, state, people and private enterprise into this equity market. For instance in India, Reliance, Dell, Satyams, Wipro and

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many other big names are examples of people, foreign companies and private enterprise investing into them to make them recognised worldwide.

Currency fluctuations and exchange rates.

Currency fluctuations and exchange rates of each and every country depends upon its GDP. As mentioned above that equity markets do play a vital role to set up or to decline a country's GDP, because people do invest in this market to get high returns.

Total GDP and GDP per head.

The distribution of income is directly related to GDP of a country. As mentioned above and since the GDP is directly related to each and every consumer's income, more than 79% of the people are employed by the equity market, and thus it concludes that India is a tertiary economy and no more an agrarian economy.

Disposable Income and Consumer expenditure.

Disposal income is an income where an individual keep it aside for investment or any other activity. As there are higher returns in the stock market and people are aware of these, individuals are investing more and more of their disposable income into stock market to obtain high returns.

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Social-Cultural Future

Distribution of Income

Distribution of Income does relate with Equity and Derivatives market, because in countries like India for, the total GDP relates to the above mentioned market, because it employs more than 79%.

Education

One of the vital aspects related to Equity and Derivatives market in India is education. This is because people day by day are more aware of the importance and the role of derivatives in the stock market .i.e. equity market.

Technological Future

Level of expenditure on R&D by organisation's rivals

The level of expenditure on R&D by organisation rivals are on a very high scale; because each and every firm want to be best and earn the most profit i.e. sellers should sell and buyers should buy it shares, therefore, the rivals expenditure is on a higher scale.

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Government investment policy

Government is playing a most important role in each and every country and giving out investment policies not only related to stock market but also relates to power sector industries, tea industries and etc.

New patterns and products

There are new up-coming products in the stock market i.e. newly listed firms sell their shares i.e. stocks on NSE.

Legal Future

Competition law and government policy

Government have put certain policies for each and every organisation to introduce its shares i.e. stocks into the market and also certain policies for sellers and buyers who play a vital role in making a sale for the companies.

Hence it clearly shows that with the help of the STEEPLE analysis, the equity market does have its own relevancy/importance in each and every country.

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Chapter 5: Conclusion and Recommendation

Derivatives are a key part of the financial system. To conclude the significance of derivative market in India, in this chapter the author has firstly taken the findings and directly has related its importance with the institutional investors of India. Thus, the findings are summarised below:

The Sellers and Buyers have knowledge and are aware of derivatives and its importance in equity market i.e. NSE, BSE. The best product-wise distribution has been made by NSE for equity market in India. The Business growth of NSE started from a mere Rs.1000 million and has reached to 250,000 million during Jan- Mar 2006 quarter and is at the booming stage at the moment possible itself. The brokers who are the intermediates play an important role for up-keeping the interest rate in the equity market. The business capital of India which is Mumbai has shown the highest Member trading i.e. business of equity market. The Sellers and Buyers are alert to the open interest rate which is calculated by the end of day to know the business growth. Today we can see that the Open Interest rates for NSE Segment for Near Month Nifty Futures have risen to 25000 million, which is quite remarkable; because it states that the sellers and buyers of the stock/shares are aware of the broker's

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holding their contracts and making equity market more reliable so that more and more users/people/clients do put in money. Sellers and Buyers have the knowledge and aware of the implied interest rate which is used to calculate the efficiency of the equity market. Sellers and Buyers also have the knowledge and aware of the implied volatility which is used to calculate to know the pricing options. Intra-day evolution of implied volatility has estimated the prices of options and found that for about 7.5% for all puts and about 6.5% for all calls was undefined, because of the intrinsic value, this was a dreadful sign for the market of equity, because it was clearly a signal of mispricing the options and the sellers and buyers had no clue about it. This shift can be attributed to low cost of transactions, low margins, etc for the equity market. The market has a much automated borrowing and lending market which is not upto the market.

In India, derivatives and equity markets hold 79% (approximately) population towards it. Sellers and Buyers who sell and buy the stock listed on the BSE and NSE (Glossary of Terms) are alert that NSE has the highest product-wise distribution for India. In the earlier chapters, we have seen that derivative to an extent, are a disaster for companies', but at the same time it has been proved wrong by Companies like IBM, Intel, Coca-cola, by making remarkable profits for themselves and making each and every individual aware that derivatives are extremely important for stock market,

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therefore the business growth of NSE has started from mere Rs.1000 million to Rs. 200,000 million (CF- Conversion Table) in a mere span of 2 ­ 3 years.

Dhingra (2000) opines that there is a clear indication to rise of these stocks to considerable amounts, if one observes the history of stock exchanges and the outcome of blue chip companies like Microsoft, IBM, Intel or Coca- Cola on the stock index; there is a clear signal of the rise of these stocks to considerable amounts. History shows that an extraordinary growth characteristic of the above stocks is related to the fundamental on which the companies have been operating under and not speculation. The current market capitalisation of Microsoft Corporation is approximately $225 billion compared to the group turnover of mere $22 million and looking back at the BP case study (1998) the answer indicates the advantage derivatives provide against various risk involving commodities, fixed assets or interest rate transaction and planning. Now the question remains that do derivatives always aid every corporation or organisation to yield profits? Industry Week (July 1998) mentions that derivatives have been plagued, which have led to media's criticism and subsequent users and accounting board's cautious attitude towards derivatives. In the past most derivatives problems are related to the uncontrolled speculation by various individuals primarily in the highly susceptible futures, forwards and swaps.

In terms of a vibrant market for exchange-traded derivatives, India is one of the most booming developing countries. This chapter recaps the strength of the modern development of India's securities market and conclusion i.e. suggestions on to how the

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institutional investors in India i.e. mutual funds companies, banks, FDI,etc play an important role in the market which are based on nationwide market access, anonymous electronics trading, and a predominantly retail market. Web 21opines that the derivative market of India had a flat line in the early 1950s, but since the new turn of millennium have gone strength to strength, doubling the turnover and outdoing expectations. Not even on the radar of the global business futures of 1990s, India has recently rocketed up to become Asia's fourth largest exchange traded derivative market, behind Korea, Japan and China. The bulk of trading is in equity products including single stocks (SSF's) and options offered by National Stock Exchange of India, with transactional values equivalent to 200% of the underlying cash market, which is not bad for a market which is five years old i.e. Indian Equity Market.

There is a lot of risk in investment in Equity Funds and is appropriate for those individual who can afford to take high risk but this high risk may either leave the investor to lose all their money with no returns as they are not safe investments or pay them high returns in the long run. Therefore, from the point of view of the investment in such type of equity funds would be safer, and investments would be secure. Thus, we can conclude by saying that the entire derivatives market and the future trends in India would be essential to compare and see how these derivatives in the equity market are used by institutional investors.

Thus it follows that Institutional Investors in India could be meaningfully classified into:

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All India Financial Institutions (FIs) Mutual Funds(MFs) Banks Foreign Institutional Investors(FIIs) Life and General Insurers

In the ensuing sections, the issues and impediments in the use of the following types of derivatives by the institutional investors in India: Equity Derivatives

The intensity of derivatives usage by any institutional investor is a function of its ability and willingness to use derivatives for one or more of the following purposes:

Risk/Trading/Market Making: Running derivatives trading book for profits and arbitrage. Risk Containment: Using derivative for risk containment purposes and hedging. Covered Intermediation: On-balance-sheet derivatives intermediation for client transactions, without retaining any net-risk on the balance sheet (except credit risk). These perspectives are considered in examining issues and impediments in use of derivatives in the ensuring paragraphs.

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BANKS

Types of Banks

Based on the differences in business practices, organisational ethos, and governance structure, it is meaningful to classify the banking sector of India into the following: Private Sector Banks (Old Generation). Private Sector Banks (New Generation). Public Sector Banks (PSBs). Foreign Banks (with banking and authorised dealer license).

Types of Risks

The two core risks are Interest Rate Risk and Credit Risk and all banks accept and wish to profit from .Foreign Currency (Price) Risk accepted by banks varies widely across the four categories. Commodity (Price) Risk accepted by bank under their scheme framed under respect of gold deposits accepted by various banks under their schemes framed under RBI Guidelines on the Gold Deposit Scheme 1999 announced in the union budget for the year 1999-2000. Equity (Price) Risk accepted by bank again is limited to their direct or indirect (through Mutual Funds) exposure to equities under the RBI prescribed 5% capital market instruments limit (of total outstanding advances as at previous year-

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end). Some banks may have further equity exposure on account of equities collaterals held against loans in default.

Equity Derivatives in Banks

Banks play an important role in the equity market, as mentioned earlier. Given the highly leveraged nature of banking business, and the attendant regulatory concerns of their investments in equities, banks in India can, at best, be termed as marginal investors in equities. Use of equity derivatives by banks ought to be inherently limited to hedging and arbitrage trading between cash market and options and futures market. However, for the following reasons, banks with direct or indirect equity market exposure are yet to use exchange trading equity derivatives (via, index futures, security-specific futures, index options or security-specific options) currently available on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE):

RBI's guiding principle by banks in the capital market instruments does not authorise banks to use equity derivatives for any purpose. RBI's guiding principle also do not authorise banks to undertake securities borrowing and/or lending of equities. This also disables also banks processing institutionalized risk management process and arbitrage trading skills for running an arbitrage book to capture risk free pricing mismatch spreads between the equity cash and options and futures market ­ and activity banks currently undertake in the fixed income and FX cash and forward markets.

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Indirect or direct equity exposure of banks is negligible and does not warrant serious management attention and resources for hedging purposes. To manage the risk of equity market exposure, and monitor use of equity derivatives, the internal resources and processes in most bank treasuries are inadequate. Inadequate technological and business process readings of their treasuries to run an equity arbitrage trading book, and manage related risks.

All India Financial Institutions

The All India FI Universe

With the merger of ICCI into ICCI Bank, the universe of all- India FIs comprises IFCI, SIDBI, IDBI, IIBI, NABARD, IDFC and EXIM. In the context of use of financial derivatives, the universe of FIs should perhaps be extended to include a few other financially significant players such as HDFC and NHB.

Equity Derivatives in FIs

The risk exposure in equity of most FIs is rather not important, and often restricted to equity devolved on them under underwriting commitments they made in the era upto mid-1990s. FIs could use equity derivatives for hedging (risk containment) purposes and

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for arbitrage trading purposes between the cash market and options and futures market. FIs too are not users for equity derivatives, for the same reason to those outlined earlier concerning with banks. FIs are not disabled by the RBI guideline from running an equities arbitrage trading book to capture risk free pricing mismatch spreads between cash and options and futures market. Yet, it can be seen that most FIs do not run an equities arbitrage trading book. This could be the possible reason because for the inadequate readiness on terms of possessing arbitrage trading skills and institutionalized risk management process for running an arbitrage book.

Mutual Funds

Equity Derivative in Mutual Funds

In the equity derivatives market, mutual funds ought to be natural players. SEBI (Mutual Funds) Regulations also authorise use of exchange traded equity derivatives by mutual funds for hedging and portfolio rebalancing purposes. And, being tax exempt, there are also no tax issues relating to use of equity derivatives by them. However, most mutual funds, whenever managed by Indian or foreign owned asset management companies are not yet active using the equity derivatives that are available on NSE or BSE.

The following impediments seem to hinder use of exchange trade equity derivatives by mutual funds:

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SEBI (Mutual Funds) Regulations restrict use of exchange traded equity derivatives to `hedging and portfolio rebalancing purposes'. The popular view in the mutual fund industry is very open to interpretation; and the trustees if mutual funds do not wish to be caught on the wrong foot. The mutual fund industry therefore wants SEBI to clarify the scope of this regulatory provision. Inadequate technological and business process readiness of several players in the mutual fund industry to use equity derivatives and manage related risks. The regulatory prohibition on use of equity derivatives for portfolio optimization return enhancement strategies, and arbitrage strategies constricts their ability to use equity derivatives. Relatively insignificant investor interest in equity funds ever since exchange traded options and futures were launched in June 2000 (on NSE, later on BSE).

Foreign Institutional Investors (FIIs)

Equity Derivatives in FIIs

Applicable SEBI and RBI guidelines, till Jan 2002, permitted FIIs to trade only in index futures contracts on BSE and NSE. RBI, only since 4 Feb 2002 permits (as a sequel to SEBI permission in Dec 2001) FIIs to trade in all exchange traded derivative contracts within the position limits for trading of FIIs and their sub-accounts.(These open position limits have been spelt out in SEBI circular dated 12 Feb 2002.) With the enabling regulatory framework available to FIIs from February 2002, their activity in the exchange

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traded equity derivatives market in India should increase noticeably in the emerging future. Evidently, several FIIs are still in the process of completing the process of their internal approvals for use of exchange traded equity derivatives on the NSE or BSE. Perhaps, the two years of successful track record of the NSE in managing the systemic risk associated with its futures and options (F&O) segment would also pave way for greater FII activity in the equity derivatives market in India in the emerging future.

Tax Issues in Equity Derivatives for FIIs:

Two crucial tax issues arise in use of equity derivatives by FIIs:

Tax character of profit or gain from equity derivatives contract - is it business income or capital gains, and if business income, is it speculative business income or non-speculative business income. Applicability or otherwise of withholding tax on profits from equity derivatives contracts. In absence of a specific finding ruling either from the CBDT or a competent Court, the income tax law on these issues remains wide open to interpretation. Technically, given the short tenure of equity derivative contracts, the better view seems to be that the profit or loss from equity derivative contracts would be business profit or /loss rather than a capital gain/loss. Interestingly, the CBDT circular dating back to 12 September 1960 interprets very generously hedging transactions in commodities, stocks and shares, to

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include portfolio and strategic hedging, and does not confine hedging transactions to a position hedge. And, any profit or loss from a hedging transaction in stocks and shares is treated as a non-speculative business profit or loss. This is significant because losses from speculative transactions are `ring fenced' and cannot be offset against capital gains or other business profits. Given that all FIIs are non-residents for tax purposes, whether any part of the profit or loss from equity derivatives transactions is liable to tax in India or not, requires technical termination about applicability of the relevant double tax avoidance treaties between India and country of tax residence of the recipient FII, the business presence (`permanent establishment') of the recipient FII in India etc. The applicability or otherwise of holding with tax on profits from equity derivatives transactions by FIIs would also have to be based on foregoing determination. Resolution of these tax issues at the policy level is perhaps crucial for the long-term development of the equity derivatives market in India

LIFE & GENERAL INSURERS

Equity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulations 2000 are silent about use of equity (or other) derivatives by life or general insurance companies. It is the view of the Insurance Regulatory and Development Authority (IRDA) that life and general insurers are not permitted to use equity (or other financial) derivatives until IRDA frames

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guidelines/regulations relating to their use. And, IRDA is yet to frame these guidelines/regulations, though it is seized of the urgent need to frame them. Life or general insurers would have to wait for these guidelines/regulations to fall in place before they can use equity (or other financial) derivatives. Assuming this happens sooner than later, most new life and general insurers have been established only in the past two years or so, and they currently have little or no equity investments at all. Given the nascent stage at which they are, it will take at least a few years before they become active investors in the equity market. Till then, use of equity derivatives would be of relevance primarily to the incumbent public sector insurance majors, namely, Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), New India Assurance Company Limited (NIA), United India Insurance Company Limited, National Insurance Company Limited, and Oriental Insurance Company Limited. And, these incumbents would have to overcome the following key impediments before they actively use equity (or other financial) derivatives:

Inadequate technological and business process readiness of their investment management function to run a derivatives trading book and manage related risks.

Inadequate readiness of human resources/talent in their investment management function to run a derivatives trading book and manage related risks; and

Inadequate willingness of insurer management to risks being accountable for bonafide losses in the derivative trading book (assuming regulations permitting

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use of equity derivatives for purposes other than hedging), and be exposed to subsequent onerous investigative reviews.

Thus, Derivative markets in equities, are at their nascent stage of evolution in India, but have significant growth potential. For this potential to be realised, as discussed in the various sections, one or more of the following issues or impediments would have to be overcome and resolved: The regulatory framework applicable to the respective market of derivative and participants would need to evolve further. The business process framework and technology of several key participants in these markets needs to be readied to manage the risks relating to their activity in the derivative market. The human resources/talent of several key participants in these markets needs to be vastly upgraded and readied to manage the exposure and risk relating their activity in the derivative market.

A framework which relieves management of public sector banks and FIs of the risk of being held accountable for the bonafide trading losses in the derivatives book and being exposed to subsequent onerous investigative reviews.

But concomitantly holds management of public sector and FIs accountable for lost opportunity profits needs to be ushered in.

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The top and senior management of several key participants need to undergo an orientation phase to familiarise themselves with the conceptual underpinnings and microstructure of these derivatives markets to help them establish an appropriate governance framework for the derivatives market activity of the participant. The tax treatment applicable to the participants in relation to the derivative contracts would need to be clarified to provide certainty about it to market participants.

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Summary of Conclusion:

Derivatives play a very important role in the up-bringing of an organization; it plays a major role in the equity market. Today, with the help of derivatives, the Indian stock exchange market has recently rocketed up to become Asia's fourth largest exchange traded derivatives market. In terms of growth of derivative markets and a variety of derivatives users, the Indian market has exceeded or equaled many other Indian markets. The variety of instruments in derivatives instruments available for trading is also expanding. Corporations, private sectors institutions, state-owned and smaller companies are gradually getting into the act. The business growth of NSE started from a mere Rs.1000 million and has reached to 2,50,000 million (conversion table) during Jan- Mar 2006 quarter and is at the booming stage at the moment possible itself. This shows that the stock market with the help of derivatives have taken for a very good progress in the Indian economy. There exist large gaps in the range of derivative products that are actively traded. In equity derivatives, NSE figures show that 90% of activity is due to index futures or stock futures, whereas trading in options is limited to few stocks, partly they are cash settled and not the underlying stocks. Exchangetraded derivatives on interest rates and currencies are virtually absent

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Although from the past experience of stock exchanges, we have seen that derivatives have yielded losses to MNC's like BP , Proctor & Gamble and etc but at the same time it has also yielded profits to MNC's like Coca-Cola, Intel etc for their organisation, thus we can see clearly that derivatives do not involve risk all the time. The institutional investors are major players in the derivatives market as mentioned earlier. According to NSE, retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for 65% of turnover in August 2006. The success of single stock futures in India is unique, as it has failed in most other countries. One reason for this success may be retail investors' prior familiarity with "badla" trades which shared some features of trading in derivatives. Another reason may be small size of future contracts, as compared to similar contracts in other countries. There is a lot of risk in investment in Equity Funds and is appropriate for those individual who can afford to take high risk, but this high risk may either leave the investor to loose all their money with no returns as they are not safe investments or pay them high returns in the long run. Therefore, from the point of view of the investment in such type of equity funds would be safer and investments would be secure.

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Equity derivatives of Banks are highly leveraged nature of banking business and the investment in the equities, banks in India are the best and termed as marginal investors in equity. Equity derivatives in FIs do not run an equities arbitrage trading book, yet it appears that there is no RBI guideline disabling FIs from running an equities arbitrage trading book to capture risk free pricing stocks. Equity derivatives in Mutual Funds are ought to be natural players in the equity derivatives market and SEBI have also authorised use of exchange traded equity derivatives for mutual fund plc. The activities in the FII in the equity derivatives market in India are in the emerging future. Equity derivatives in Life and General Insurers are silent about the use of equity or other derivatives. The market has a very automatic borrowing and lending market which is not upto the market. Put-Call issues are very good indicators of the derivative market.

The second key factor where the equity derivatives market has as yet not made substantial progress is the large-scale utilisation of IT systems in trading, arbitrage, market marking, etc. When a few dozen underlying generate thousands of derivative securities, it is essential to have computer systems primarily driving the actual implementation of trading strategies. They will have a profound impact upon the nature of pricing and liquidity on this market, when these systems fall

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into place. The government, although aware of the equity derivative market, has not yet made any substantial progress in the IT systems but derivatives markets earlier had its own declined stage and now have its flourishing stage in India. Thus, to conclude the whole scenario of the derivatives importance in the equity market as mentioned earlier that derivatives had made tremendous losses to companies like Proctor and Gamble, etc but at the same time it has helped companies like Intel, IBM, and etc to make tremendous profits to them and also have international recognition. Thus, from above, we can see that derivatives are vital and how they are important for each and every institutional investors such as Mutual Funds, Banks, Foreign Institutional Investors (FIIS), All Financial Institutions (FIs), Life and General Insurers. We have seen from above that derivatives on its own and in the equity market have pulled almost 79% of India's population towards it, and now the booming period has come and everyone is aware that derivatives are making the country's GDP and are directly linked with the disposable income of each and every entity. One major question, as looking forward is concerning institutional participation on the equity derivative market. As with most of the financial sector innovations of the last decade, individuals have displayed intellectual capacity and a speed of exploiting new ideas which has just not been found with finance companies. Globally, mutual funds and banks are key players on the equity derivative market. In India, owing to variety of government and regulatory problems, this has just not materialised. Web19 states that 0.79% of the NSE derivatives turnover in December 2005 came from institutional users. Most of the legitimate difficulties of mutual funds in terms of

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regulatory restrictions have been eased out through SEBI governing the mutual funds. Rules governing insurance companies and FIIs have been partly eased. Banks, however, continue to face stringent regulatory hurdles. We can see an enormous increase in liquidity .Hence we say that institutional investors do play a major role for derivatives and equity market which in turn enhance the country's GDP.

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Recommendations

Further Research in this area after a span of year's time would be worthwhile to do because the derivatives market and equity market are not stable. A research based on strategic alliances between BSE (Bombay Stock Exchange), NSE (National Stock Exchange) and NADAQ could be seen in the upcoming years. Since derivative and equity market depend on exchange rate on a large scale and they are of a very fluctuating nature, further research on exchange rate would be prudent. At the same time, research on the interest rate would be sensible; because, as exchange rate have a fluctuating nature, interest rate depends upon the exchange rate of any country for its progress and on the whole interest rate are co-related with the derivatives and equity market. In the derivative market more scripts are required in the F&O segment. The lots size need to be reduced from Rs.2,00,000 to Rs.1,00,000. Markets should be stock settled instead of cash settlement. Since the equity market depends on any individual's disposable income, further research should also be looked into disposable income. To have a consistent method of accounting for losses and gains from the derivatives trading, a proper framework to account for derivatives needs to be developed.

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Research on the institutional investors in India i.e. FIs, Mutual Funds, Banks, Life and general insurers would be meaningful to do on a large scale, because these are the major players who use derivatives and invest in equity market. Harmonisation of regulations is required. Strengthening of SROs is critical for safeguarding the derivative market.

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Books Referred :-

A Srikanth and Anup Menon (2003) ­ Index Futures - the Scope of Arbitrage. A.K. Srithar (2000) ­ Managing Index Funds. A.N. Oppenhei, (2000) ­ Questionnaire Design, interviewing and attitude measurement. Ajay Shah (2000) ­ Equity Market India Alan C. Shapiro (2000), Prentice- Hall ­ `Multinational Financial Management'. Avadhani S (2000) ­ Investment Management and Mutual Funds (2nd Edition). Bansal M., Bansal N. (2003) - Derivatives & Financial Innovations, Bombay Stock Exchange. Bharti V (1999).Pathak, Pearson Education ­ `Indian Financial System.' Blaxter (1997) ­ How to Research. David Silverman (2000) ­ Do Qualitative research. Dr. Narendra Jhadav (2000) ­ Indian Banking. Donald S. Tull and Del I. Hawkins (1993)- Marketing Research E. Sirisha (2001) ­ Stock Market Derivatives: Role of Indices ( 2nd Edition) Flower (1985) ­ How to collect Data. G R K Murty (2000) ­ Indian Derivatives Market: Issues at Stake. Hathaway (1995) ­ Qualitative VS Qualitative research analysis. Hull J. (1995) ­ Introduction to Futures and Options Market (1st Edition). J Marlowe (2000) ­ Hedging Currency Risk and Options and Futures.

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Jason Greenspan (1997), Jaico Publishing House ­ Financial Futures and Options - In Indian Perspective'. John C. Hull (1997), Pearson Education ­ Fundamentals of Futures and Options Market'. L.M. Bhole (1999), Tata Mcgraw Hill Publishing ­ Financial Institutions and Markets'. Mark Suanders (2000) ­ Research method for business students. Micheal C Volker (2004) ­ Glossary of Business Jargons (Business Dictionary). Motley (1986) ­ Qualitative research analysis. Murti and Murti (2000) ­ Derivative Trading in India. Naresh K. Malhotra (2004) - Marketing Research : An Applied Orientation Patwari D.C. and Bhargava A.(2006),- Options and Futures An Indian Perspective, Jaico Publishing, Mumbai Sahoo (1997) (2nd Edition) ­ Financial Derivatives and its products. Sommer and Sommer (1991) ­ How to evaluate research. Susan Thomas (1998) ­ `Indian Securities Market ­ A Review' National Stock Exchange of India Limited. Sushil Jiwarajka (2000) ­ Focus on Performance and Productivity (1st Edition). Vohra N.D., and Bagri B.R. (2006) - Futures and Options, (2nd Edition), Tata Mc.Graw Hills, New Delhi Warren Edwardes (2002) ­ Key Financial Instruments.

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Journals Referred:-

Dhingra G. (2004), `An understanding of financial derivatives of financial derivatives', The Chartered Accountant, March Industry Week July 1998. Kandathil C.(2003), `Indian Derivatives Markets ­ Structural Issues,', Chartered Financial Analyst, December Verma J. R. (2002), "Mispricing of Volatility in India Index Option Market", Working Paper 2002-04 -01, April 2002, IIM Ahemdabad). Agarwal A.K.(2004),`Credit Derivatives: A concept Note', The Chartered Accountant, March. Christian J. (2003)`Global Derivatives Markets- The road ahead', Chartered Financial Analyst, December Gulati S. (2003)`Curreny Options', Chartered Financial Analyst, November Sisodiya A.S.(2003)`Credit Derivatives: Is Indian Banking Sector Ready', Chartered Financial Analyst, July J.R. Verma Committee on measures for risk containment in the derivatives market. Kabra Committee on Forward Markets.

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`Derivatives Core Module Workbook' National Stock Exchange of India Limited. `Indian Securities Market ­ A Review' National Stock Exchange of India Limited. Website Referred:-

Web1 Derivative Definition (Online) (Cited on 27th July 2006) Available from <www.cperformance.com/glossary.htm>

Web 2 Definition of Forward Contract (Online) (Cited on 27th July 2006) Available <www.ers.usda.gov/Briefing/RiskManagement/glossary.htm> from

Web 2 Definition of Forward Contract (Online) (Cited on 27th July 2006) Available from < http://wikipedia.org/wiki/Forward_contract>

Web 3 Definition of Futures Contract (Online) (Cited on 28th July 2006) Available from <http://en.wikipedia.org/wiki/Futures_contract>

Web 4 Definition of Futures Contract (Online) (Cited on 28th July 2006) Available <http://www.investorwords.com/2136/futures_contract.html> from

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Web 5 Definition of Options Contract (Online) (Cited on 28th July 2006) Available <http://www.investorwords.com/3482/option_contract.html> from

Web 6 Definition of Swaps (Online) (Cited on 29th July 2006) Available from <http://en.wikipedia.org/wiki/Swaps>.

Web 7 Derivatives and Global Economy (Online) Cited on 29thJuly) Available from <http://www.nex.net.au/users/reidgck/COLLAP.HTM>

Web 8 Myths behind Derivatives (Online) ( Cited on 30th July 2006) Available from

<http://www.thehindubusinessline.com/business/iw/2000/06/11/stories/08 11h017.htm>

Web 9 Are Derivatives Disastrous (Online) (Cited on 31st July 2006) Available <http://www.mayin.org/ajayshah/MEDIA/1998/disasters.html> from

Web 10

National Stock Exchange Of India Ltd (Online) (Cited on 5th

August 2006) Available from <http://nseindia.com>.

Web 11 NSCCL (Online) (Cited on 6th August 2006) Available from

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<http://www.nseindia.com/content/nsccl/nsccl_fospan.htm >.

Web 12 Definition of Research (Cited 10th August 2006) Available from <www.research.psu.edu/orp/HUM/train/definitions.html >.

Web 13

HIPAA definitions (Online) (Cited on 12th August 2006)

Available from <www.preemptinc.com/defitions.html>

Web 14 Questionnaire Design (Online) (Cited on 15th August 2006) Available from

<www.cc.gatech.edu/classes/cs6751_97_winter/Topics/quest-design/>

Web 15 August

Definition of Secondary Research (Online) ( Cited on 15th 2006) Available from

<wps.pearsoned.co.uk/wps/media/objects/1452/1487687/glossary/glossary .html>

Web 16 August

Definition of Qualitative Research (Online) ( Cited on 15th 2006) Available from

<http://www.okstate.edu/ag/agedcm4h/academic/aged5980a/5980/newpag e21.htm>

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Web 17 Definition of Quantitative Research (Online) ( Cited on 15th August 2006) Available from

<http://en.wikipedia.org/wiki/Quantitative_research>

Web 18 Explanation of the Research Process (Online) ( Cited on 15th August 2006 ) Available from

<http://www.uta.fi/FAST/FIN/RESEARCH/research.html>

Web 19 Steps in Research Process (Online) Cited on 15th August 2006 ) Availablefrom<http://www.marketingteacher.com/Lessons/lesson_marketi ng_research.htm>

Web 20 Introduction to Marketing Research (Online) ( Cited on 15th August 2006 ) Available from <http://

www.marketingteacher.com/Lesson/lesson_marketing _research.htm

Web 21 FOW & FO Week ­ Derivatives Intelligence for the risk Professional (Online) (Cited on 16th August 2006) Available from <http:www.fow.com/articles/fow_articles.asp?storyCode=265>

Web 22 Information on Indian Stocks, equity, business, finance, money , debts, law, management, shares (Online) (Cited on 16th August 2006) Available from <www.indianfoline.com>

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Web 23 Welcome to National multi commodity exchange of India LTD (Online) (Cited on 17th August 2006) Available from <www.nmce.com>

Web 24 MCX ­ Multi Commodity Exchange of India LTD (Online) (Cited on 19th August 2006) Available from <www.mcxindia.com>

Web 25 My StocksOptions.com ­ Stock Options, ESPPs, and Restricted Stocks (Online) (Cited on 20th August 2006. Available from <www.mystockoptions.com>

Web 26 Equitymaster ­ The Investors Best Friend (Online) (Cited on 21st August 2006) Available from <www.equitymaster.com>

Web 27 Net Present Value ­ Definition of Net Present Value, What is NPV (Online) (Cited on 21st August) Available from

<http://www.Ise.co.uk/FinancialGlossary.asp?searchTerm=&iArticleID=4 9>

Web 28 Capital Asset Pricing Model ­ Definition of CAPM (Online) (Cited on 21st August) Available from

<http://www.Ise.co.uk/FinancialGlossary.asp?searchTerm=&iArticleID=4 53>

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Web 29 Definition of Call Option (Online) ( Cited on 22nd August 2006) Availablefrom<http://www.Ise.co.uk/FinancialGlossary.asp?searchTerm= &iArticleID=437>

Web 30 Definition of Put Option (Online) ( Cited on 22nd August 2006) Availablefrom <http://www.Ise.co.uk/FinancialGlossary.asp?searchTerm=&iArticleID=1 74>

Web 31 Definition of Currency Swaps (Online) ( Cited on 22nd August 2006) Available from

<http://www.investopedia.com/terms/c/currencyswap.asp>

Web 32 Definition of Interest Rate Swaps (Online) ( Cited on 22nd August 2006)Availablefrom <http://www.Ise.co.uk/FinancialGlossary.asp?searchTerm=&iArticleID=7 37>

Web 33 NSE ­ NSCCL ­ F&O ­ NSCCL SPAN (Online) (Cited on 25th August2006)Availablefrom <http://www.nseindia.com/content/nsccl_fospan.htm>

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Web 34 NSE - ISMR 2005 (Online) ( Cited on 25th August 2006 ) Available from www.nseindia.com/archives/us/ismr/us_ismr2005.htm

Web 35 Facts on Derivatives (Online )( Cited on 25th August 2006 ) Available from <http://www.nseindia.com/content/press/faqfo.pdf>

Web 36 NSE India monthly figures( Online)( Cited on 25th August 2006 ) Availablefrom <http://www.nseindia.com/archives/fo/monthly/DU_062006.pdf>

Web 37 Indian Derivative Market (Online) ( Cited on 26th August 2006) Available from <http://www.ny.frb.org/research/economists/sarkar/derivatives_in_india.pdf>

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Appendices

Appendix A:

Illustration of Forward Contract

Two parties C and D enter into a forward contract on 1st March. C agrees to purchase 2000 shares of `F Ltd'. For a pre-determined price of $1 three month forward. On the fixed future date here on, C will get the 2000 shares and will pay the price i.e. $2000.00 and D will deliver the shares and shall receive the money.

Figure 1: Forward Contracts

Specified Price C Specified Asset D

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At the maturity date the contract is settled. The holder of the short position delivers the asset to the holder of the long position in return for cash amount equivalent to the deliver price. Forward contracts are not dealt on exchange but traded over the counter. These have certain flexibility and self- regulatory. There is privacy in the forward market that is not there in the exchange trading. Counter party default risks and lack of liquidity are the main draw backs of a forward contract. Forward contracts are being used in India on a large scale in the foreign exchange market to hedge currency risk.

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Appendix B:

Illustration of Future Contract Centres into a futures contract on 1st September to purchase 100 equity shares of `F Ltd' at a price agreed of $1 in December. If on the maturity date (as determined the rules of the exchange for the month of December) the price of equity stock falls to $0.50, C will have to pay $0.50 per share or otherwise if the price of equity stock rises to $2, C will receive $1 per share.

Figure 2: Futures Contracts

If the market price falls to $0.50 $0.50 per share C If the market price rises to $2 $1 per share D

Future contracts are normally settled as compared to forward contract only through the difference between the strike price and market price as on the date of maturity.

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Appendix C:

Illustration of Option Contract

C pays $ 4000 to buy a `December 103' call option on a $ 100,000 US Treasury bond at an exercise price of $103. If the price falls below $103, the maximum amount that C would lose is the premium paid and if the price rises above $103, C will gain from the difference.

Figure 3: Options Contracts

C

D

Pay on the at maturity date Premium $ 2,000

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Appendix D:

Illustration of a Swap Contract

According to Avadhani (2000) if Mr `A' has borrowed from Mr. `X' at LIBOR + 2%. Mr `A' to cover the transaction from unanticipated fluctuations in the interest rate agrees to pay a fixed rate of 9% to Mr. `B' and in return Mr. `B' agrees to pay a floating rate i.e. LIBOR +2% to Mr. `A' although the actual payments between Mr. `A' and Mr. `B' will take place only on net basis. The net result of the transaction for each parties will be as follows: Mr. `X' will receive the amount at LIBOR + 2% Mr. `A's liability is fixed at 9% Mr. `B' liability depends on the fluctuating rate i.e. LIBOR.

Let us take two cases 1. LIBOR = 10% In this case Mr. `A' will pay to Mr. `X' at the rate of 12%. Mr. `B' will pay Mr. `A' at the rate pf 3%. Hence the net liability of Mr. `A' is 9% 2. LIBOR = 5% In this case Mr. `A' will pay to Mr. `X' at the rate of 7% and Mr. `A' will pay to Mr. `B' at the rate of 2% . Hence the net liability of Mr. `A' remains the same at 9%.

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Figure 4: Swaps X

Floating LIBOR + 2% Floating LIBOR + 2% A A

Fixed 9%

Swaps have an informal market among dealers as they are not traded on organized exchanges. As distinguished from futures and options swaps market affords privacy that may not be there in exchange trading. The inherent limitations of a swap market may be summarised as follows: A party has to find a counter party willing to take the opposite side of the transaction. A swap agreement being between two counter parties cannot be altered or terminated early without the agreement of both the parties. Parties to the swap must be certain of the creditworthiness of the counter party as the risk of counter party default is always there.

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Appendix E:

Illustration of a Hedge

According to D.C. Patwari and Anshul Bhargava for example, in February 1996, an importer had to make a payment for a contract entered in December 1995. In December 1995, the rate of exchange was Rs. 32.20 for a US Dollar, which shot up by 6th February 1996 to Rs.38.60. This indicates that the value of the US Dollar against the rupee rose by almost 20 %. If the importer has imported good worth $1 crore, then his cost increased by Rs. 6.40 crore. In businesses where margins are not even 5%, one can afford a loss of 20 %. The unhedged imports spelt doom for the importer. Similarly, a firm exported goods on 6th February 1996, expecting to realize Rs 38.60 per dollar, but could only get Rs.34.80 per dollar in March 1996. Its sale proceeds thus went down by Rs.3.80 per dollar- a 10% loss in sale value. Fluctuations of 4-5% over a month's time are quite normal. Considering this, currency futures and options are necessary to hedge this kind of risk.

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Appendix F:

Illustration of a Speculator

According to D.C. Patwari and Anshul Bhargava for example take the case of Shyam who is a Commodity Exchange member. He thinks in December 2004, that the March 2005 cotton futures contracts are underpriced, so he buys in March 2005 cotton futures contracts. Till January 2005 he holds his long position. When the price of future contracts in March 2005 increases over a period of time, he sells them and makes profits. He can deal in commodities worth lakhs of rupees without investing in them. His investment is the margin money, which is required to be paid to the clearing house.

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Appendix G:

Illustration of a Arbitrageur

According to D.C. Patwari and Anshul Bhargava for example, suppose ITC quoted in the spot market at Rs.1000 per share and its 3 months futures at 1,030. Then one can purchase ITC shares at Rs.1000 each in the spot market by borrowing 8% p.a. for 3 months and selling ITC futures for 3 months at Rs.1030. While the cost is Rs. 1,020 (1000+20), the futures are sold at Rs. 1,030, providing the trader with an arbitrage profit of Rs. 10 per share before brokerage.

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Appendix H:

Global Derivative Market

The Global Derivative Market has been remarkable for the calendar year 2005. The National Stock Exchange of India making huge strides and moved upward in global ranking. The recent data (covering exchange traded derivatives, including futures, options on futures and options on securities) published by Futures Industry Association has stated that the total number of contracts traded increased by 8.92% during year 2004 ­ futures contracts rising by 16.27% and option rising by 4.60% during the year 2004. As shown in the Table 1, volume rose in all sectors of the market but the category with the greatest was trading in equity index derivatives such as index options, index futures and options on index futures.

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Table 1: Volume by Category

(In million) Global Jan-Feb 2006 Equity Index Interest Rate Individual Equity Agricultural Energy Foreign Currency Non- Precious Metals Precious Metals Other TOTAL 787.11 461.41 457.95 64.51 54.29 31.57 19.28 12.03 0.36 1,888.51 Jan- Feb % 2005 521.33 396.78 360.28 44.08 39.35 20.66 15.06 8.15 0.21 1,405.89 Change 51.0% 16.3% 27.1% 46.4% 37.9% 52.8 % 28.0% 47.7% 74.4% 34.3%

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(In million) Global 2004 2003 % Change Equity Indices Interest Rate Individual Equities Energy Products Agricultural Commodities Non- Precious Metals Foreign Currency/Index Precious Metals Other Total Volume 3,775.43 2,271.25 2002.43 243.46 326.15 105.23 105.37 60.56 0.86 8,890.74 3,959.17 1,881.27 1,560.17 217.56 311.01 90.39 77.85 64.46 0.66 8,162.54 -4.64 20.73 28.53 11.90 4.87 16.42 35.35 -6.05 -6.50 8.92

In Table 2 are the details of the Top 20 contracts for the year 2004. Kospi 200 options of Kofex led the table with more than 2.5 billion contracts in 2004 followed by Euro ­ Dollar Futures of CME. Kospi 200 is still maintained its position of number 1, though witnessed a huge decline of 11.14%. NSE too, has been making huge strides by moving upwards in the global ranking. NSEIL ranked (1st) in the single stock future category (Table 3) in the year. NSE has been ranked 17th in the global futures and options volume in 2004 against its rank of 21st in the

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previous year (Table 4). In the Top 40 Futures and Exchanges of the World, NSE stands 10th position in 2004 against 15th in the year 2003. (Table 5).

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Table 2: Top 20 Contracts for the year 2004 Rank Contract 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Kospi 200 Options 3 Month Euro- bond Futures Euro- Bond Futures TIIE 28 Futures 10 Year T-Note Futures E- Mini S&P 500 Index Euro-Bobl Futures 3- Month Euribor Futures 3 Month Eurodollar Options Euro-Schatz Futures DJ Euro Stoxx 50 Futures 5 year T- note Futures Interest rate Futures

(in millions- net of Individual equities) 2004 2003 %Change

Exchange Kofex CME Eurex MexDer CBOT CME Eurex Euronext.liffe CME Eurex Eurex CBOT BM&F

2,521.56 2,837.72 -11.14 297.58 239.79 206.03 196.12 167.2 159.17 157.75 130.6 122.93 121.93 105.47 100.29 77.17 72.95 71.41 63.15 57.34 56.88 55.61 208.77 244.41 162.08 146.45 161.18 150.09 137.69 100.82 117.37 117.37 73.75 57.64 67.89 56.08 61.79 73.67 60.00 41.17 62.20 42.54 -1.89 27.12 33.92 3.73 6.05 14.57 29.54 4.74 4.84 43.01 73.99 13.67 13.27 15.57 -14.28 -4.43 38.16 -10.59

E-mini NASDAQ 100 futures CME 30 ­ Year T- bond Futures DJ Euro Stoxx 50 Options CAC 40 Index Option No 1 Soya bean Futures 10 ­ Year T- Note Options Kospi 200 Futures CBOT Eurex Euro next DCE CBOT Kofex

Source: FI Futures Industry, March/April 2004. The monthly magazine of the FIA.

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Table 3: Futures on Individual Securities (Stock Futures) Exchange National Stock Exchange of India RTS Stock Exchange Euronext Spanish Exchange( BME) Stockholm Borsa Italiana Athens Derivatives Exchange JSE South Africa Budapest Australian Warsaw Mumbai SFE Corporation Hong Kong Copenhagen 2003 25,572,505 31,782,174 7,004,235 12,492,568 1,424,890 4,68,083 477,464 4,85,919 618,261 267,630 93,005 103,939 47,822 18,654 310 2004 44,020,670 39,061,704 13,491,781 12,054,799 4,533,805 1,734,356 919,679 883,587 706,386 459,801 87,888 38,383 29,986 17,274 1,685

Source: WFE 2004 Annual Report and Statistics

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Table 4: Global Futures and Options Volume Rank 2004 49 50 51 52 53 54 55 56 57 58 59 60 61 2003 51 49 50 53 42 48 55 56 54 61 58 52 57 Wiener Borse Winnipeg Commodity Exchange One Chicago Minneapolis Grain Exchange Bupapest Commodity Exchange Yokohama Commodity Exchange Copenhagen Stock Exchange New Zeland Futures Exchange NQLX CBOT Futures Exchange Mercado Termino de Buenos Aires BrokerTec Futures Exchange MidAmerica Commodity Exchange Exchange Volume 2004 2,242,475 2,054,296 1,922,726 1,416,282 1,300,726 1,164,811 704,006 497.181 257,000 91,332 85,593 --2003 % Change

1,392,529 61.04 1,842,776 11.48 1,619,194 18.75 1,133,731 24,92 3,673,978 -64.60 1,852,158 -37.11 762,050 493,250 858,900 -39,610 -7.62 0.80 -70.08 -116.09

1,356,825 -142,298 --

Source: Future Industry, March / April 2005. The month magazine of FIA

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Table 5: Top 40 Futures Exchanges (Volume figures do not include options on futures) Rank 2004 2003 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 1 2 3 4 5 6 7 10 8 15 11 9 13 12 14 17 16 18 19 Eurex Chicago Mercantile Exchange Chicago Board of Trade Euronext.liffe Mexican Derivative Exchange Bolsa de Mecandorias Exchange New York Mercantile Exchange Dalian Commodity Exchange The Tokyo Commodity Exchange 684,630,502 668,650,028 2.39 664,884,607 530,989,007 25.22 489,230,144 373,669,290 30.93 310,673,375 267,822,143 16.00 210,355,031 173,820,944 21.02 173,533,508 113,895061 52.36 Exchange Volume 2004 2003 % Change

133,284,153 111,789,658 19.23 88,034,153 74,447,426 74,973,493 87,252,219 36,141,561 68,570,154 75,159,690 41,831,862 49,817,798 40,079,750 33,258,385 35,356,776 24,315,286 21,084,727 17.42 -14.68 86.51 -2.04 -13.17 21.84 -2.70 1.24 6.64 -20.33 12.13 21.92

National Stock Exchange of India 67,406,562 London Metal Exchange Korean Futures Exchange Sydney Futures Exchange Zhengzhou Commodity Exchange Shanghai Futures Exchange International Petroleum Exchange Singapore Exchange OMX Exchanged Tokyo Grain Exchange 67,171,973 65,261,326 50,968,901 48,474,548 40,577,373 35,466,941 28,169,379 27,264,123 25,705,687

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20 21

20 23

New York Board of Trade

23,955,212

18,822,048 14,947,523

27.27 32.54

JSE Securities Exchange South 19,811,664 Africa

20 22 23 24 25 26 27 28 29

20 22 21 26 24 25 27 34 31

New York Board of Trade Tokyo Stock Exchange MEFF Taiwan Future Exchange Osaka Securities Exchange Bourse de Montreal Hong Kong Exchange & Clearing Mercado a Termino de Rosario Tokyo International

23,955,212 18,331,928 17,592,259 14,911,839 14,583,283 12,900,821 11,884,152 7,735,890

18,822,048 15,965,175 17,110,745 9,953,118 13,231,287 10,676,279 8,174,652 2,708,313 4,771,917

27.27 14,82 2.81 49.82 10.22 20.84 45.38 185.64 60.43

Financial 7,655,510

Futures Exchange 30 31 32 33 34 35 36 37 28 41 30 29 33 35 32 36 Italian Derivative Market Eurex US Budapest Stock Exchange Osaka Mercantile Exchange Fukuoka Futures Exchange Kansas City Board of Trade Kansai Commodities Exchange Malaysia Berhad 38 37 Winnipeg Commodity Exchange 2,030,455 1,811,616 12.08 Derivative 6,551,211 6,186,008 4,252,595 3,842,533 3,036,733 2,834,799 2,803,812 7,302,565 -4,939,893 6,162,589 2,739,383 2,634,424 3,441,365 2,009,460 -10.29 --13.91 -37.65 10.85 7.61 -18.53 31.01

Exchange 2,632,543

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39 40

38 39

One Chicago Oslo Stock Exchange

1,922,726 1,748,742

1,619,194 1,201,319

18.75 45.57

Source: Future Industry, March / April 2005. The month magazine of FIA

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Appendix I: Questionnaire

1. Do you about Derivates are? And how does it revolve around the equity markets? a) Yes b) No c) N/A

2. Which would you rate product-wise distribution of Turnover of NSE in 2004 ­ 2005? a) Index Futures b) Stock Futures c) Index Options d) Stock Options

3. What do you think be the daily average turnover i.e. growth of business at NSE a) 8000, b) 10000, c) 12000, d) above12million Rs.

4. Do you understand by the term "Daily open interest"? a) Yes b) No c) N/A

5. What do you think could be the daily open interest at NSE for Index Futures? a) 8000, b) 10000, c) 12000, d) above12million Rs.

6. What according to you could be approximate close price for Nifty Futures from 2004 -2005? a) 8000, b) 10000, c) 12000, d) above12million Rs.

7. Do you understand by the term if "Daily implied interest rate"?

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a) Yes b) No c) N/A

8. What according to you could be approximate daily implied interest rate from 2004 ­ 2005? a) 8000, b) 10000, c) 12000, d) above12million Rs.

9. Do you understand by the term "Implied Volatility"? a) Yes b) No c) N/A

10. What according to you could be the intra-day evolution of implied volatility on the 9th Dec 2002? a) 0.15, b) 0.25, c) 0.35, d) 0.45, e) 0.55

11. What according to you would be the NIFTY volatility smile at 3pm on the 9th Dec 2002? a) 0.15, b) 0.25, c) 0.35, d) 0.45, e) 0.55

12. What according to you could be the volatility smile at the close of day i.e.9th Dec 2002? a) BCCL, b) Infosys, c) Satyams, d) BPL

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Appendix J: Conversion Table:

India Currency (Rs) 88.57/- Rs 885.7/- Rs 8,857 /- Rs 88,570 /- Rs 885,700 /- Rs 8,857,000 /- Rs 88,570,000 /- Rs 885,700,000 /- Rs

UK Currency (Pounds) 1 Pound 10 Pounds 100 Pounds 1000 Pounds 10000 Pounds 100000 Pounds 1000000 Pounds 1000000 Pounds

USA Currency (Dollars) 0.528 Dollar 5.28 Dollar 52.8 Dollar 528 Dollar 5,280 Dollar 52,800 Dollar 528,000 Dollar 5,280,000 Dollar

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Derivatives Markets in India

Appendix K

1. NPV Web 27 opines a figure which represents the total of future cash inflows from a project, less cash outflows, inflation and/or a required rate of return. Net Present Value (NPV) = Present Value (PV) ­ Amount Invested.

2. CAPM Web 28 opines Economic theory describing the relationship between returns in security and risk.

3. APT Arbitrage Pricing Theory.

4. Call option Web29 opines a call option bestows the right to buy an underlying asset at a given price. The short seller also known as writer has an obligation to sell shares to the holder, if the option is exercised. In simple terms it is an agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.

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5. Put Option Web 30 opines an option provides the holder the right to buy (but not the obligation) or sell a normally fixed quantity of an underlying asset on, or before, a specified date in future. The two types are: Puts and Calls. Buyers of the call option have the right to buy the underlying asset at a given price. Sellers (AKA writer) are obliged to sell, if the option is exercised. Conversely, buyers of put options have the rights to sell the asset at the given price. The writer of a put option is obliged to buy from the holder (buyer) if the option is exercised. 6. Currency Swaps Web 31 opines that contract which commits two counter parties to exchange streams of interest payments in different currencies for an agreed period of time of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

7. Interest Rate Swaps Web 32 opines an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit, or manage, its exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

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8. OTC - Other Trading Contracts. The OTC market of derivative contracts has been existing in some form or other since many years.

9. Teji ­mandi - Call options and Put options.

10. Jota phatak ­ Straddles

11. Bhav- bhav ­ Stake

12. BSE ­Bombay Stock Exchange.

13. NSE ­ National Stock Exchange.

14. SPAN Web 33- opines it is a Risk Parameter for the Stock Market and the objective SPAN is to identify overall risk in a portfolio of futures and options contracts for each member.

15. SEBI ­ Securities and Exchange Board of India.

16. PRISM ­ Parallel Risk Management System.

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17. NSCCL - The National Securities Clearing Corporation Ltd.

18. F&O Segment in NSE ­ Futures and Options segment in NSE

19. Underlying Market Price - A price which acts as the security upon which a futures or options contract is based.

20. Volatility (variability) of the underlying instrument price fluctuations in the equity market.

A measure of

21. Strike Price - Is the price when the seller sells and get a profit while selling i.e. the seller sell the share i.e. equity when the market is on a boom.

22. Time to Expiration - opines Interest rate future contracts shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contract shall expire on the previous trading day. Further, where the last Thursday falls on the annual or half- yearly closing dates of the bank, the expiry and the last trading day in respect of these derivatives contracts would be pre-poned to the previous trading day.

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